What are dividends and should you care about them?

18th October 2021

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By Jon Rowe

When investing in the stock market, there are two ways to make money. One way could be that the stock price rises beyond the price that you paid for it, making you a tidy profit – this is called capital gain. The other way to make money from an investment is to receive money directly from the company that you are investing in, from the profit that they make – this is called a dividend. Dividends are viewed favourably by many investors that are more risk averse, who view it as guaranteed income. On the other hand, others may view dividends as unnecessary. So, should you really care about dividends or not?

 

The main aim of a company is to maximise shareholder wealth and there are many ways that this can be achieved. When companies make a profit, they have to decide whether they should use that money to fund a new project that will make the company higher profits in the future or whether they should distribute profits to shareholders through dividends. Obviously, if there is no new project to fund, most companies logically distribute the funds to shareholders. Typically, companies that are in this situation are mature companies and a modern day example of where this is the case would be Apple. Shareholders placed enormous pressure on Apple to pay more money out as dividends, due to the fact that they had so much money sitting around and no new projects to invest in. As a result, Apple have increased their dividend steadily since 2012. Despite this, many people believe that Apple should have offered a larger dividend payment but most recently Apple revealed plans for a number of new projects including the ‘Apple card’, justifying their decision not to increase their dividend by a larger amount. Therefore, companies that provide large dividend payments often do not have new projects to use their profits on and this could be a bad sign for your investment in the long term.

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An alternative perspective is that certain types of investor will invest in particular companies, based on their own risk characteristics. People that have a low tolerance for risk tend to prefer dividends. As a result, it may be the case that the shareholders of a company are like-minded and would all prefer to receive a dividend. Therefore, the company may meet the preferences of the investors and offer a sizeable dividend that they try to increase over time. Dividends may act as a sign of stability in a company. For example, technology companies like Amazon are famous for not offering a dividend. This is because the projects that they pursue are of higher risk and therefore offer higher rewards. The investors of Amazon are likely to be more accepting of risk and are likely to encourage the use of profits in high risk projects. A consequence of this is that the stock price of Amazon may be very vulnerable to higher ups and lower downs, which is certainly the case. The stock price of Amazon went down by 22.18% in 2014 and then went up by 117.78% in 2015. As much as the performance in 2015 is exceptional, the stock performance of Amazon is somewhat unpredictable. In contrast, Coca-cola famously offer a sizeable dividend but their stock price went up by 2.2% in 2014 and up by 1.75% in 2015. Therefore, dividends often represent stability and predictability.

 

Overall, investing for dividends is a respectable investment strategy, especially if you are someone that does not particularly like risk. Dividends can often represent stability but equally can represent a company that is mature and lacks new exciting projects to invest in. Dividends can sometimes be a concern and may result in a loss in investment earnings. That’s why it’s really important to fully research the companies that you invest in to understand why they are offering a dividend – or not.

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