Earning money when a company generates profit is one of the perks of being a shareholder. The income we earn comes in the form of a stock dividend and is separate from any gains from price appreciation.
These dividends are often paid quarterly and are determined and declared at the discretion of the board. For companies doing exceptionally well, the board will decide to increase dividends. In times of difficulty, the board may lower dividends or cancel them altogether. When the board declares a dividend, the company communicates the amount paid in dollars per share.
Apples to apples
Companies also have the option to pay out non-cash dividends.
These dividends are almost always in the form of additional shares in the company. The stock dividends, also known as dividends in kind, are issued as a percentage of current holdings.
These types of dividends are infrequent and going out of style as most companies prefer to buy back shares instead. For the rest of these lessons, we’ll be referring to cash dividends.
Advantages of dividend stocks
Dividend-paying stocks are great for investors looking to take moderate risks. Companies that pay dividends regularly tend to have more stable stock prices than those companies that don't. We've looked at how bonds bring portfolio stability here. The dividend payments on a stock are similar to interest payments on bonds. Thus, dividend stocks inherit some of the stable properties of bonds.
The chart below shows the aggregate price of 374 dividend-paying stocks compared to 63 non-dividend-paying stocks over 12 years, including 2008. We see that dividend stock prices don't experience as large swings in price as non-dividend paying stocks.
Surprisingly, we've seen companies recently being reluctant to cut dividends even in times of hardship. In 2008, the S&P500 lost 37% of its value due to the subprime mortgage crisis. Instead of shoring up cash, many companies increased dividends for the year. We see an eventual decrease in dividends in 2009 due to the companies feeling the effects of the recession. However, we'll see that the dividend payout recovered much faster than the stock prices if we look closely.
The increased cash dividends during the recession years greatly helped portfolios even when asset prices were down!
The stability of dividend stocks helps us ride out volatility and market downturns. If we remember from our lesson on risk, a stock that goes up 50% followed by a decrease of 50% doesn’t arrive at the same value. Adding dividend stocks ETFs will dampen the possible ups and downs in our portfolio and the cash payments will help our portfolio compound faster.