Do dividends matter for investors? What are the benefits of dividends? The astronomical growth in the stock price of some companies that do not pay a dividend has led some investors to believe that dividends do not matter. For instance, Amazon (AMZN) does not pay a dividend, and arguably the stock keeps going up over time in anticipation of more future growth. Hence, some investors have then concluded that dividends don’t matter.

However, the short answer is “Yes, dividends matter for investors.” There are distinct benefits of dividends to investors. In aggregate, dividend-paying stocks provide higher returns with lower volatility than stocks that do not pay a dividend. Dividends are a return of cash to shareholders. Further, dividends have provided nearly 40% of total return over long periods. Some investors also rely on dividends for income. So, dividends have benefits for investors.

We will first discuss and summarize dividends and then answer the question posed in this article.

What Is A Dividend?

Dividends are typically cash distributions that public companies pay out periodically from their earnings to shareholders. Most companies pay dividends quarterly in the U.S. Some companies pay dividends monthly, and a few pay dividends bi-annually or annually. It is much more common for a European company to pay a dividend bi-annually or annually.

Dividends are a type of income that shareholders receive for each share of stock that they own. For example, an investor holds 100 shares of Company A. Let’s assume that Company A pays a dividend of $0.10 per share. This fact means that the investor receives $10 in cash.

Some companies also pay stock dividends. A few companies pay both cash and stock dividends. An excellent example is Tootsie Roll (T.R.), which pays a cash dividend of $0.36 per share and a ~3% stock dividend annually.

A few companies pay special dividends, which are much more infrequent and can be paid at any time. For example, Costco (COST) is a company that pays a special dividend every few years. Before COVID-19, there were a few companies that paid an annual special dividend. One example of this was Cracker Barrel Old Country Store (CBRL). But the number of companies cut or suspended their dividends due to the coronavirus pandemic reduced this list.

Regardless of the type of dividend, dividends are set and approved by a company’s board of directors and the shareholders.  A dividend payment has four parts: an announcement or declaration date, an ex-dividend date, a record date, and a payment date.

A Brief History of Dividends

The history of dividends is an interesting one. It starts in 1602 in Holland. In the United States, York Water Company (YORW) starts its streak of consecutive dividend payments in 1816. The company has over 200 years of paying a dividend. It is also the oldest publicly traded utility in the country. Fast forward to modern times, and Microsoft (MSFT) starts paying a dividend, followed by Apple starts paying a dividend in 2011.

In the U.S., dividend yields averaged about 5% from 1871 to 1982. The bottom of the bear market in that year and changes in investment outlook, creation of the 401(k) plan in 1980, proliferation of tax-deferred savings, and lower taxes on capital gains versus dividends pushed the average dividend yield down from roughly 5% to about 2.5% from 1983 to 2010. It hit a low of about 1.1% in 2000. Today, the average dividend yield is even lower at about 2%.

In general, equity prices have grown faster than dividends since 1983, causing a drop in average dividend yield. That said, it is clear why dividends matter to investors over their history. Both investors and companies understood the benefits of dividends for essentially the inception of the idea. Dividends provided a substantial part of the total return in the past.

Dividend Metrics

There are two primary metrics for dividends: dividend yield and payout ratio. Of course, there are other metrics and calculations, but these are the two most fundamental.

Dividend Yield

The dividend yield shows the annual rate of return that a shareholder receives from the dividend. It is a measure of valuation since it depends on the share price. Hence, it is a way to measure the return of the dividend of any new purchase. The dividend yield is calculated using the following equation:

\( Dividend~Yield = {Annual~Dividend~Per~Share \over Stock~Price~Per~Share} \times 100\% \\\)

Payout Ratio

The payout ratio is an indication of dividend safety and the financial condition of the company. It depends on annual earnings. If the dividend takes is too high a percentage of the earnings, it is likely not safe. Dividend payout ratios over 100% mean that the earnings do not cover the dividend payout. The following equation calculates the dividend payout ratio:

\( Dividend~Payout~Ratio = {Annual~Dividend~Per~Share \over Earnings~Per~Share} \times 100\% \\\)

Do I Need To Pay Tax On Dividends?

The short answer is “Yes.” The IRS considers the dividend to be income. This fact is the case even if you reinvest all your dividends through a DRIP stock plan back into the same company.

Despite being considered income, dividends can be taxed at a lower rate than your regular income if it is a qualified dividend. This is because qualified dividends are taxed at the long-term capital gains rate.

Ordinary or non-qualified dividends are taxed at your regular income tax rate, typically higher. For example, distributions from REITs, MLPs, and some other types of special entities are not considered qualified dividends.

Dividend Tax Rates

The differences in dividend tax rates can be significant, especially at high incomes, one of the essential benefits of owning stocks that pay dividends. Nevertheless, it is clear from comparing tax rates between regular income and qualified dividends, owning dividend paying stocks is advantageous, especially at higher incomes.

Which Companies Pay Dividends?

Typically, large established companies with stable earnings and cash flow pay dividends. But established small-cap or mid-cap companies with similar characteristics may also pay dividends. In addition, companies in specific sectors tend to pay dividends more often. These sectors include consumer staples, utilities, oil and gas majors, financials, and healthcare. Consumers staples companies and utilities are favorites of investors seeking dividends. For example, Coca-Cola (K.O.) has paid a growing dividend for 58 years. The current dividend yield is approximately 3.5%. The combination of dividend yield, dividend growth, and some capital appreciation has been very popular for dividend growth investors.

Master Limited Partnerships (MLPs)

Companies structured as master limited partnerships or ‘MLPs’ pay a particular type of dividend called a distribution since they must do so. MLPs are typically pipeline companies and are referred to as midstream companies. They store and transport oil, natural gas, and chemicals. MLPs are pass-through entities, so they are not the same as regular corporations. Instead, MLPs pass through cash flow as distributions.

Real Estate Investment Trusts (REITs)

Companies structured as real estate investment trusts or ‘REITs’ also pay dividends. REITs are also pass-through entities. They pay no federal income tax as long as the REIT pays out at least 90% of its taxable income as dividends to its investors. For this reason, REITs are also dependent on capital markets to fund future growth. They must issue new debt or additional equity to fund acquisitions or new projects. Dividends from REITs are not qualified.

Dividend Growth Stocks

This blog and focus have been, for the most part, dividend growth stocks. These are stocks that pay a growing dividend over time. There are several advantages and risks to dividend growth investing. This type of stock is categorized by the consecutive number of years that a company pays a growing dividend.

Companies that have done so for 50+ years are referred to as Dividend Kings. Companies that have paid an increasing dividend for 25+ years are known as Dividends Champions. Those that have increased the dividend for 10 – 24 years are called Dividend Contenders. Lastly, companies that have raised the dividend for 5 – 9 years are known as Dividend Challengers. Take a look at the dividend stock lists in the different categories mentioned above.

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