Dividends are the single most important source of shareholder value over the long term. They’re steady, real, and can genuinely fund your financial freedom dreams.
When a company earns money, they have a number of ways to reward shareholders. Two of the most common are paying dividends and through share buybacks. Dividends are a way of transferring earnings from the company directly to shareholders who then have the option to take the dividend or reinvest it back into more shares of the company. Share buybacks reduce the number of outstanding shares of a company and thus increase the per share earnings for remaining shareholders.
The five advantages of dividends:
- Consistency
- Inflation Protection
- Profitability Litmus Test
- Passive Reinvestment
- Alignment of Interests
Table of Contents
Consistency with Dividends
In companies where a dividend has been paid and preferably increased for many years, a dividend culture is created. This is crucial as a board of directors that previously increased a dividend will be loathe to revoke it. They know that shareholders depend on regular dividend payments.
Investors look to dividend policy more than they rely on explicit company guidance. You can trust signals sent by dividend policy more than words spoken.
Words are cheap, money pays.
Inflation Protection
Inflation is the hidden tax that quietly eats away at the strength of every dollar in existence.
Central banks continuously increase the amount of dollars in circulation. It’s one of the ways they manage their monetary policy. There are benefits, but there are also risks to anyone not properly invested.
We all know that things used to cost less, but it’s not as straightforward as thinking things used to be cheaper. If everything goes up, including wages, then it’s just about how much each things increases in cost/value.
When I Was a Kid…
As a very stark example of the ability of inflation to decimate the value of a dollar over time, think of The Coca-Cola Company (KO). You’ve probably seen the signs that show a single Coke beverage being sold for five cents. For a comparable single-serve option today, an individual may be inclined to pay two bucks or more!
The cost of all goods sold has increased over the years. The question is whether the purchasing power of consumers and investors has also increased. That comes down to how well dollars have been put to use.
Companies that increase their dividends faster than the rate of inflation are the gems to own. As the cost of goods continues to rise, so should the investor’s dividend payments. There is nothing to fear about inflation if dividends are rising steadily.
Many people lament that it costs too much to go out for dinner or fill up a tank of gas.
You’ve heard such complaints, right? Of course you have.
These are the common refrains of the working person.
There’s a simpler way, though. Simply own stock in best-of-breed companies. Collect the dividends and, ideally, reinvest them.
Profitability Litmus Test
The stock market is rife with stories of corporate greed. It seems every other week we’re hearing about a new investigation into practices of Big Business.
In such a shady environment, what certainty does the small investor have that they won’t have their hard-earned investment dollars wiped out in one fell swoop?
Dividends and Their Reliability
While there are no guarantees in life, dividends provide what we call the Profitability Litmus Test.
You can fake dividend payments for a while. Debt can be taken, shares can be issued. It’s possible to hide a leaky hull at harbour.
After a while, the truth gets set free.
Take a company such as Johnson and Johnson (JNJ) who has increased their dividend for over fifty consecutive years. Think about how difficult it would be for a company to somehow manage to do that without actually being incredibly profitable and well managed. It would be virtually impossible. JNJ has paid investors billions of dollars. It still is paying billions of dollars. Doing so year in and year out for over half a century is actual proof that JNJ is a powerhouse.
You can’t fake a dividend growth track record forever. Eventually, the truth wins out.
Passive Reinvestment of Dividends
Reinvesting dividends represents one of the greatest and simplest ways to compound wealth over time. It offers an opportunity to increase your stake in the company you’ve chosen while getting the advantages of a dollar cost averaging approach (buying regularly without trying to time the market).
The three synergies of dividend growth investing:
- New money is used to buy shares of a dividend paying company.
- Dividends received are passively reinvested into more shares of the company.
- The company organically increases the size of its dividend payments.
While some people reinvest the dividends directly into new shares of the same companies they already own, others prefer to allow the dividends to accumulate in their discount brokerage accounts and then make a lump sum purchase once enough money has built up. In either case, using the dividends you receive to build larger positions is simply intelligent investing.
Building multiple streams of income is one of the strongest ways to secure your financial footing. Think of a massive oak tree; the roots go into the ground in every which direction across incredible expanses. As the tree grows, the roots deepen and the foundation becomes even more solid. Improving your finances is no different – you need many deep roots branching out to strengthen you.
Alignment of Interests
How can all of us get along? It’s easy if we’re all making a handsome profit.
When companies pay dividends, they make it possible for shareholders to increase their positions in the company or maintain their current stake while still being rewarded for remaining loyal. This aligns the interests of shareholders, management, the board of directors, and the employees of the underlying company. When everyone has an opportunity to get paid, everyone’s interests are aligned.
With companies that do not pay a dividend, a shareholder has to sever the ties by selling shares to raise capital to fund their lifestyle. This creates a conflict of interest where investors are incentivized to hope for short term fluctuations upward so they can sell their stake and decrease their interest in a company. If someone is waiting simply for a favourable event so they can sell out, they are unlikely to have the best interests of the company in mind. That is true of people at all levels—whether investors, employees, or otherwise.
Conclusion
Dividends are one of the most important factors for investing success in the stock market. They get too little media coverage because the simple fact is that brokerage houses don’t make a whole lot of money when an investor patiently accumulates dividends and trades infrequently.
If you enjoy getting paid even while you sleep, take a vacation, or are out on the tennis courts, dividends are worth more than a passing glance.
Thanks for reading.
Do you invest using dividends as part of your Get Rich strategy? What do you love about dividends that we didn’t mention?
Full Disclosure: Long KO, JNJ
Pictures courtesy of pixabay.com
