Why do some companies pay dividends while others refuse to? Is there a sort of reasoning behind each company’s decision to withhold or otherwise execute these sorts of payments? What advantage is there to owning stock in companies that pay dividends versus non dividend paying stocks?
In this article, we will look at all of these questions. Let’s determine what are the differences between dividend-paying companies and non dividend paying companies. Also, let’s see which stocks may be a better fit for your personal portfolio and life goals.
What Are Dividend-Paying Stocks?
Dividend-paying stocks have been around almost since the inception of markets, in the late 1800s. Representing a portion of the profits made by a company, they are paid regularly to stockholders. The amount that is paid in dividends is expressed by the company as a percentage of its stock price.
Some companies, such as Aberdeen Asian Income, Alliance Trust, Bankers, BioPharma Credit pay dividends as often as every quarter. Others only pay once or twice a year. Some examples of companies that pay bi-annual dividends include 3i Infrastructure, BB Healthcare, and Hansa Trust. Generally speaking, you can get a good idea of what type of dividend payments you can expect from a company by looking up their historical dividend payments.
There are also certain companies that have come to be known colloquially as “Dividend Champions” or “Dividend Aristocrats”. These are companies that have a history of increasing their dividends each year for the past 25 years or more.
What Are Non Dividend Paying Stocks
There are also certain companies which offer non dividend paying stocks. These firms are called “growth” companies because they prefer to reinvest all their net earnings in their development. Their strategies are focused on achieving stock price appreciation, which will lead to greater returns for investors.
The investments that these companies make will increase free cash flow (FCF). This is what stock prices are based on. As FCF increases, an individual should find that their share prices on the stocks they own will also increase. This happens because the expectation of a future dividend payment grows with the stock as the FCF increases. That dividend should also be far larger in the future. As such, people are willing to pay more for the potential of that opportunity.
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The best example of a growth company that does not pay dividends is Google. The company believes that the shareholders will benefit the most if the earnings are retained and used to further grow the business. For instance, those who invested $10.000 in Google shares in 2004 have now a return of around $90.000. Another example of a growth company is Berkshire Hathaway.
Paying vs. Non-Paying Stocks
What is the difference between the two? Dividend companies tend to put less of their retained earnings back into operations investment. They give out more of their retained earnings to shareholders.
A typical dividend payout ratio for this sort of company could be around 40%. This would mean that they would pay out 40% of the retained earnings to shareholders in dividends. They would reinvest the other 60% of back into company operations. They need that to generate more sales.
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In this manner, a shareholder receives the majority of the value in owning a stock with a dividend-paying company from the dividends that he or she receives.
Alternatively, companies that don’t pay dividends choose to reinvest 100% of their retained earnings back into company operations. A company that reinvests all of its retained earnings into new projects produces increased retained earnings in the future (assuming they are successful). This increases a company’s free cash flow with which to operate.
In turn, investors will pay more for shares of companies that have increasing free cash flow levels. The reason is that it is possible that those investors would receive greater dividends in the future.
As a result, an individual who owns non dividend paying stocks may find that their “capital” increases very quickly as share prices also increase. This is known as capital appreciation. Furthermore, it is possible that the capital appreciation from non dividend paying stocks is worth more than the dividends from companies that pay dividends annually.
So, Which One is Best for You?
Generally speaking, individuals that purchase dividend stocks are looking to find steady, recurrent income. This means that dividend stocks are great for retirees. The reason is that dividends can provide them with the immediate cashflow they need for day-to-day expenses. Also, they don’t have to worry about the price volatility that is inherent to the market.
Alternatively, companies that don’t pay dividends can be great purchases for individuals with a long time horizon for investing. Companies that do not pay dividends may prove to beat dividend-payers over the long haul, and Google is a good example in this respect. That makes them great investments for younger individuals.
However, dividend payers are more likely to generate positive returns to investors on a monthly basis and generally outperform non-dividend payers.
Clearly, there are benefits to owning both dividend stocks and non dividend stocks. A good portfolio will likely have a mixture of both. Dividend stocks provide that stable income that we know will come in. That is regardless of market swings or black swan events. On the other hand, non dividend payers provide that huge capital appreciation that we all want.