The value of a stock doesn’t only consist of what traders are willing to pay for growth; there is also a premium built into the price for the amount of money the company is already paying out in cash to shareholders in the form of dividends. Most investors consider dividends as investment income because they pay cash in a regular cycle (often by the quarter). Certain investors prefer a high income to prospects about capital appreciation from profit growth. A large company that has grown to fill its market space can pay dividends for a long time in a (somewhat) predictable way. Utility companies are a common example. The entire United States has been electrified, and massive growth for power companies is impossible.
However, those companies have a predictable stream of income and pass the profits on to shareholders in the form of dividends. Investors (such as retirees) that want to preserve their principal and draw down their earnings prefer stocks that are dependable dividend payers. Companies that pay high dividends with a good track record tend to perform well in declining markets. Cash income is a psychologically valuable thing in bad times, and a long history of high dividend payments is perceived by some investors to provide a sort of price floor for this cohort of stocks. In good times, dividend payments cannot match the capital appreciation of the sexy growth stocks so they will be out of favor.
Before a dividend is distributed, the company must first declare the dividend amount and the date when it will be paid to shareholders. To keep people from buying the day before a dividend is paid and selling the day after, you must hold a stock for a period before you are eligible to receive the dividend. The last date when shares can be purchased to receive the dividend is called the ex-dividend date. This date is generally two business days prior to the date of record, which is the date when the company reviews its list of shareholders.
Unlike bond coupon payments, dividends are not guaranteed. If a company falls on bad times and doesn’t turn a profit during a particular period, then dividend payments may be cut or eliminated. Conversely, some strong companies have increased their dividends year over year for many years. This cohort is often referred to as the dividend aristocrats. The rise and fall of dividends present a double whammy for investors. The rise in dividends means that you will have more income from holding the stocks, and news of the increase will signal to other investors that the underlying company is strong and growing profits. This will cause buying to rise, and that will, in turn, inflate the market price of the stock. This is great, but the problem is that the converse is also true.
If a company cuts dividend payments, then investors that own the stock will make less in the form of dividend income. It also means that some investors will take the cut as a sign of weakness in the company and sell their shares. This selling pressure causes the price of the stock to fall. Income investors must do their homework like any other investor. The bottom line of any company (except for unproven growth stocks) is of critical importance to investors. This also means that factors that influence the bottom line are important as well. Investors often make the mistake of thinking that old stalwart companies are static and that you can buy and forget. Ask any General Electric investor, and they will tell you that all good things must end.
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