The Importance of Dividends

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Dividends are a portion of the profits of the company distributed to stockholders after its managers have determined that those profits will not be needed to grow the business. Dividends are often paid by mature businesses.

Dividend payments are dependent on a number of factors. Industry growth and consistent performance are key. The performance of a dividend-paying company is determined by its annual income and its dividend yield. The abilities of the CEO and the management team to lead the company in the right direction, weather downtrends, and seize opportunities are all factors indicating the quality of the dividend. Mature companies with established markets tend to pay dividends at a much higher rate than younger businesses.

Cash dividends are the most common form of dividend and are the type most coveted by investors who are looking for income from their investment.

The board of directors determines when the dividend will be distributed. On the DECLARATION DATE, the board declares its intention to pay a dividend, creating a liability on the company's books. Each time a dividend is declared, the board of directors must approve it, and then a date of payment to shareholders of record must be set.

The real importance of dividends to you as an investor lies in your ability to reinvest them, usually without cost, in the mutual fund or the stock. Without a doubt, the easiest way to reinvest your dividends is to agree to do so when you sign up for an IRA or a company-sponsored plan like a 401(k), or simply when you buy a mutual fund outside of your tax-deferred accounts. But the easiest way to do it with stocks is by using DRIPs or DPPs.

DRIPs simply means Dividend ReInvestment Programs. These programs are often the least expensive way of buying a stock; they are sometimes even free of charge. Currently, there are more than 600 companies that provide a program that allows individual investors to use their dividends to buy stock on a recurring basis. Most of the programs are straightforward and easy to use.

Direct public purchase (DPP) offers the investor a way to buy stock directly from a company. The vast majority of the companies offering this require you to access the program through a brokerage portal like FirstShare or MoneyPaper. Each requires you to join the program before you buy your first share of stock; then, once you have become registered with the company of your choice, the business will contact you and allow you to set up further investments.

Using Dividend Cover

Wall Street uses a financial statistic called dividend cover. The math works like this: Dividend cover equals earnings per share divided by dividend.

A company with a dividend cover of 2 is considered very reliable. A dividend cover that falls between 1 and 2 is a relatively accurate indicator of increased risk. In this case, the dividend has become a burden on the profits of the company, but not to such an extent that it is a danger sign for investors. When the dividend cover falls below 1, the company is paying more in dividends than it can afford and will probably need to reduce the amount it distributes if it cannot increase its profits. Substantial increases in profits are difficult for companies that have reached a level of maturity that does not allow for rapid growth. A dividend cover of 1 might also suggest that earnings from previous years are being used to cover the distribution.

Source/Disclaimer: Excerpted from Investing for the Utterly Confused by Paul Petillo. Copyright © 2007 by The McGraw-Hill Companies.

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