What You Need to Know About Dividends

Transcript

The word dividend gets thrown around a lot, and misunderstood probably even more. Here's what I hear all the time. Number one, a high dividend yield means it's a good investment. Number two, high-dividend-paying stocks are a safe, conservative choice. Number three, dividend income is basically extra money your portfolio spits out on top of whatever your investment is already doing. By the end of this video, the hope is that you'll have a much better handle on what a dividend is, why companies pay them, and why some things most people believe about dividends could cost them money.

So what is a dividend? Let's use pizza as an example. Say you and four friends open a pizza place. Each of you puts in $10,000. The restaurant does well, and after a year there's $2,000 sitting in the business bank account that the restaurant doesn't really need. So you five owners decide to split it. Each of you gets $400. That's a dividend in a nutshell: the business sharing profits with the people who own it. Before that $400 left the restaurant, your share was worth $10,000. The moment the business hands you that dividend, that $400, your share is now worth $9,600. So you have $9,600 sitting in the business and $400 in your hand in cash. Same total, the money just moved from one pocket to another.

Now, you could take that $400 and spend it, or you could put it back into the business, and that's called reinvesting your dividend. Dividends are not free money. They are a transfer of value from the company to you. You already owned it. Now you just hold it in cash instead of shares.

So how does this play out in the actual stock market? I'm going to get a little technical here, so bear with me, and it'll just be for a minute. When a public company decides to pay a dividend, there are a few dates that matter. One is the declaration date, and it's exactly how it sounds. This is when the company declares or announces a dividend. They tell the world, we are paying a dividend, here's the amount, and here's the date you have to be a shareholder by to receive it. Think of it like a snapshot. The company looks at the list of owners on that day, and those are the ones who get paid.

Then we have the ex-dividend date. The ex-dividend date basically says, if you want the dividend, you have to own the stock before the ex-dividend date. If you buy on or after the ex-dividend date, you don't get that dividend. The previous owner does, the one who sold you the stock. And here's where it connects back to the pizza place. On the ex-dividend date, the stock price drops by roughly the amount of the dividend. For example, if the stock was trading at $50 a share and pays a $1 dividend, on the ex-dividend date it will open that morning around $49 a share. The market is adjusting for the cash that just left the business, just like your share in the pizza restaurant dropped from $10,000 to $9,600 once you received the dividend in cash.

So looking at this timeline, at surface level you might think, I'm going to buy this stock right before the ex-dividend date, get on the list of owners, collect the $1 dividend, and then sell. Isn't that free money, Nick? It's not, because the share price drops by the amount of the dividend. So yes, you collected a $1 dividend, but the share price is now $1 less. You're right back where you started, except now you have to pay tax on the dividend.

Why does a company pay a dividend at all? Let's jump ahead five years with our pizza restaurant. Now it's so profitable that cash is piling up faster than the owners can put it to work. You can only open so many locations. You don't need a new oven every year. At some point the business is generating more than it can sensibly reinvest, so maybe they start paying a dividend. But there are a few other reasons too. The obvious one is returning profits to the people who own it. But paying a consistent dividend is also a good signal to the market. It says, we're confident enough in our future earnings to make a public commitment. Cutting a dividend later is painful, and investors punish it hard, so companies don't start paying one unless they mean it.

And then there's the human piece, which is my hot take on why dividends are so popular. There's a name for it, the bird-in-hand theory, and you may have heard it before. Quite a few people prefer certain cash over uncertain future gains. Even when the math might favor waiting, a dividend showing up in your account feels real and tangible. You can feel the return on your investment in a way that a stock price going up just doesn't. And the feeling is real. There's nothing wrong with it. It's human nature to prefer certainty over uncertainty.

Businesses that pay a consistent dividend tend to be similar. They're mature and profitable. Think a utility company, a big bank, or a consumer brand that's been around for 80 years. These businesses aren't doubling in size every two years, but they generate steady cash and they share it. Flip that around, and you have a fast-growing company that sees opportunity everywhere and can't spend cash fast enough. It takes every dollar of revenue and puts it back in: more product, more people, faster expansion. They're not paying a dividend because they think they can grow your money better by keeping it. Warren Buffett has never paid a dividend at Berkshire Hathaway. His argument was, if he can compound that dollar better inside the business than you can once he hands it to you, then why would he hand it to you?

So we know what a dividend is, and why companies pay them. What is a dividend yield? Yield is simply this: what percentage of what you paid comes back to you in cash each year as a dividend. Back to the pizza restaurant, you put in $10,000, the restaurant paid you $400, so your yield is 4%. For every $100 you invested, $4 came back to you in cash this year. That's yield. A lot of people see a stock with a 9% dividend yield and think that means they're getting a 9% return. But yield and your actual return are two different things. A stock that pays a 9% yield but loses 15% of its value didn't give you a 9% return. It actually cost you money. A high dividend yield alone doesn't tell you enough. It also doesn't tell you whether returning that cash was even the right call. Some investors would rather own a company that keeps every dollar and puts it to work. Whether a dividend serves you depends entirely on the company, the business stage, and what you actually need from your portfolio. So if there's one takeaway, it's that just because a stock pays a dividend doesn't mean it's a great investment.

Well, aren't high-dividend-paying stocks safe and a little conservative? Some are, and some are very much not. If you wanted a benchmark of a healthy dividend-paying company, where would you look? A company that has raised its dividend every single year for 25 consecutive years is a great place to start. There's actually a name for these companies. They're called dividend aristocrats. And the name fits: aristocrat meaning old-money nobility, proven, long-standing. To raise a dividend year after year for a quarter century, the underlying business has to actually be making more money year after year. So these companies tend to hold up better in rough markets, because the business underneath is genuinely durable.

But even these good dividend payers still come with an opportunity cost. Say you're 25, you have $20,000 to invest, and you heard that buying high-dividend-paying companies is a good move. So you buy a handful and collect the dividends. It feels responsible, it feels good. But those same companies are growing slowly by design. They're returning cash to you instead of reinvesting aggressively, because there's nowhere else to put it. Meanwhile, growth companies that reinvest every dollar are compounding at a higher rate over that same stretch. At 25, you have 40 to 60 years of compounding remaining, and you probably don't need the dividend income, nor the tax consequences that come with it. If you're 65, it's a whole other story.

To put a bow on this, picture two restaurants of equal quality. One pays out profits as dividends every year. The other reinvests every dollar back into expanding and improving the business. Ten years later, the reinvesting restaurant has grown significantly larger, and your ownership stake is worth considerably more. It also came with a lot more headaches. The dividend-paying restaurant handed you cash along the way, grew a little more slowly and controlled, and is still doing fine. Neither path was wrong. The dividend investor got income. The reinvestment investor got growth. Total return is what matters: what the investment grows to over time, counting both the price appreciation and any dividends received. That's the number worth focusing on. A dividend is simply a portion of your investment returning to you in cash. What you do with it from there is up to you.

Hopefully you learned something today. Onward and upward. Until next time.

Hosted byNick GeorgeCFP®, ChFC®, CLU®, IWA™FounderView bio →

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