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 which stocks may be a better fit for your personal portfolio and life goals.
What Are Dividend-Paying Stocks?
A Dividend-Paying stock is a share of a company. You can purchase it. It will pay dividends at least once a year. Dividends are the payment that you receive for maintaining ownership of the company. Dividend-paying stocks have been around almost since the inception of the markets. That would have been in the late 1800s.
Some companies pay dividends as often as every quarter. Others only pay once or twice a year. 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”. These are companies that have a history of increasing their dividends each year for the past 25 years or more.
Typically, individuals that look to invest in dividend-paying stocks are hoping to obtain a stable stream of income from their investments.
What Are Non Dividend Paying Stocks
There are also certain companies which offer non dividend paying stocks. Typically, these companies are called “growth” companies. It can be a very bad sign if a company does not pay a dividend to its shareholders.However, this is not necessarily true. It can also be a very good thing that a company offers non dividend paying stocks.
Truly, the goal of every company is to pay a dividend at one point or another. However, by paying dividends on their stock a company is reducing the number of funds that it can reinvest into its business operations. By instead opting to have non dividend paying stocks, a company can invest more into its business.
In turn, these investments that the company makes will increase the company’s 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.
What is the Difference Between Dividend Stocks and Non Dividend Paying Stocks
So, now we know how each type of stock works. 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. Retained earnings is the money that the company keeps after all expenses and taxes have been paid.
A typical dividend payout ratio for this sort of company could be something like 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.
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. In many ways, this makes sense. It allows a company to grow quicker. Still, it may also dumbfound investors. It may seem that they are being paid nothing to hold shares in these sort of companies.
However, this is not the case in reality. A company reinvests all of its retained earnings into new projects. They produce 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. They could be a result of current company decisions if the company did, indeed, decide to begin paying dividends.
As a result, an individual who owns non dividend paying stocks may find that their “capital” increases very quickly as share prices also increase. Capital means the money they invested into purchasing shares of the company. We call this 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?
Typically 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 have been proven to beat dividend-payers over the long haul. That makes them great investments for younger individuals. Some examples include Google and Berkshire Hathaway.
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. Non dividend payers provide that huge capital appreciation that we all want.
As always, please consult with your investment advisor before making any investment decisions. Your personal time horizon, risk tolerance, and life goals will play a large role in determining what kind of investments you will make. A personal advisor can help you make these decisions, be it dividend paying or non dividend paying stocks.