Are Dividends Good (Part 1)

From Financial Literacy Wiki

Are Dividends Good (Part 1)

During bear markets, savvy investors will increasingly look out for safe harbours to put their money into. Inevitably, high dividend yielding stocks will readily come to mind, as investors look to them for security and the potential double rewards that it may bring – dividend and capital gains. So are dividends always good?

To answer the question, let us look at some basics. Dividends are usually cash paid back to the shareholders as a share of returns that the business or company made in the last financial period. The dividend yields paid out by companies vary across different industries, The best dividend usually come from companies that create their own products.

Reinvesting the dividend paid out by the companies not only enables an investor to increase his holdings but also to compound his returns.

If the price of the stock falls more than its dividend, and this can happen during a bear market, the dividend yield will rise. And a higher dividend yield is a ticket to higher returns. Investors can reinvest their dividends and accumulate more shares during the bear markets and the lower price allows investors to own more shares than they would be able to buy if the stock had not declined. This would reduce the average price he has paid for shares of the company. This reduction of average price increase his chance of making a profit from his holdings when he sells. Even if he does not sells, the increase in shares would also increase his amount of dividend received from the company.

Hence dividends not only give the investors constant liquidity and cash flow, it also protects the investors in a bear market and enhances his potential returns during market recovery, assuming that the investor reinvest his dividends.

For large growth companies, where growth is essentially needed to expand business or consolidate market position, it is essential that such companies used their funds to expand their business instead of paying dividend. Thus it is expected that they would not be paying any dividend.

For such companies, if they want to reward investors, what they can do is instead used the extra monies to buy back and cancel these shares. This will reduce the number of outstanding shares of company thus increasing the earnings per share, which in turn would drive up share prices.

Another way to rewards investors is to reduce debt. By reducing debt, companies would reduce its interest expenses and obligation to pay. This reduction would improve the company’s credit standing, allowing it to borrow funds easily and also at a lower interest rate, and also increase profits in the future due to the reduction in expenses.

Thus whether a company pays dividend or not really depends on the industry that the company is in and in which growth phase the company is in as well.