When you own a stock, you are entitled to a share of any profits that the company makes. If you hold 100 shares of a company that has 1,000 shares of stock outstanding, you are a 10% owner of the business and all that entails, such as earnings and voting rights.
While you are a partial owner of the company, company executives will decide how to spend profits. They could decide to retain the profits and use them to invest in growing the business, or the company may give some of those profits to you, the shareholder, directly. When profits are sent to shareholders in this way, they are called "dividends."
Dividend stocks are a popular investment choice. There are three primary reasons for this.
- Companies need cash to operate, and those that pay dividends cannot adjust their reports to make it look like they have more cash than they do.
- Dividends make companies manage their finances to make sure there is enough cash to pay shareholders.
- Dividend stocks attract investors when there is an economic slowdown, boosting their portfolios and the business simultaneously.
Companies With Dividends Must Keep Cash on Hand
While companies must adhere to guidelines set forth by the generally accepted accounting practices (GAAP), there are a lot of estimates and assumptions in accounting. With each instance of estimation and assumption comes an opportunity for companies to manipulate their income statement to make profits appear higher or lower than they actually are.
That is where dividends come to the rescue—you can't fake liquid cash, which is the most common form of dividend payment. When a dividend payment shows up in your brokerage account, for instance, that money is yours. You can reinvest it by buying more stock, or you can transfer it to a savings account, or you can withdraw it as cash and spend it.
Thus, when companies offer dividend payouts while boasting conservatively financed balance sheets, it boosts investor confidence that the company is making the money it claims. When a company regularly increases the amount of its dividend, that can inspire further confidence.
Dividends Demand Fiscal Discipline
Along with accurate financial reporting comes the need to turn a profit. Therefore, as dividends improve the accuracy of income statements, they also add to the pressure for managers and executives to practice fiscal discipline.
A company wants to keep cash on hand when there's a dividend payment date approaching. If an investment opportunity, like a potential acquisition, lands on the CEO's desk, that person must decide whether the investment will generate the cash required to meet dividend obligations. If the investment is too risky, and there isn't enough cash to easily cover all of the company's obligations (including dividends), the CEO will likely pass on the offer.
On the other hand, if an opportunity lands on a CEO's desk, and that person doesn't have to worry about having the cash to cover dividend disbursements, then they may be willing to operate at a loss—hoping that the investment will eventually generate profit.
Dividend "Yield Support" Slows Bearish Forces
During major meltdowns of the stock market, strong dividend stocks tend to hold up better than their non-dividend-paying counterparts. One reason for this is known as "yield support." To better understand this concept, let's work through a hypothetical example.
Dividends are often calculated as a percentage. This is known as the 30-day SEC yield, and it lets investors know how much they'll be paid in dividends for every dollar they spend on a stock. If a company's stock costs $100 per share, and it pays a dividend of $3 per year, then that stock has a yield of 3%.
Now imagine that a broad economic slump takes hold, major stock indexes fall, and this company's stock isn't spared. While the stock used to cost $100 per share, it now costs just $50. The stock price lost half its value, but as it fell, the stock's yield doubled to 6%. It now costs just $50 to ensure an annual dividend payment of $3.
An investor looking for opportunities in a slumping economy may be drawn to the guaranteed 6% yield of this company's stock. Investors stepping in to take advantage of this dividend yield may help to slow the downward momentum, and they could even reverse it. This is called "yield support."
Yield support can break down if the yield becomes excessively high. In that case, an investor may worry that the dividend is unsustainable, and the company may not have the cash to pay the dividends. Another factor that can impact yield support is whether the company has cut dividends in the past. Investors want to see a history of raising dividends, not lowering them. If the company has cut dividends in the past, investors may fear that they'll do so again.
The Bottom Line
Lots of investors hope to find the next great IPO. While it's exciting to get in on the ground floor of a successful company, you shouldn't overlook opportunities with companies that are already successful. Cash-generating giants can line your pockets with the cash from dividend payments. As you collect your dividends, a stock's value could grow—perhaps slowly, compared to successful IPOs, but much more steadily.