by David Novak
Recently a client asked me a series of questions about dividends, as it pertained to one of the stocks in his investment portfolio. After we talked for awhile, it dawned on me that I may be assuming all of our clients know more about dividends than they actually do.
By definition, a dividend is a sum of money paid regularly by a company to its shareholders out of its profits. Investors who own stock in a public company may be eligible to receive dividends if they own the stock as of the ex-dividend date. Most American-based companies that pay dividends do so on a quarterly basis, while many foreign-based companies only pay dividends once a year, based on their annual profits.
Paying a dividend every three months would seem to imply a certain stability to this quarterly payment, and many investors assume that it’s guaranteed. This is not at all the case, as the payment is ultimately a reflection of the future profitability of the company, which is obviously uncertain. According to Standard & Poor’s, last year 394 companies reduced their dividends, a 38% increase over 2014.
And these are not confined to small, obscure companies that you’ve never heard of. Look no further than General Electric, which in 2009 cut its dividend 68%, after paying a dividend for more than 100 years, and increasing the amount of this dividend for more than 50 years.
Another client misconception about dividends is that the payment is an extra form of return, and that buying the stock right before its record date will result in “found money”. This is incorrect, since the price of the stock will be reduced by the amount of the dividend two days before this record date (this is the date investors must be on the company’s books to receive the dividend). For example, if a stock trading at $31 has an upcoming quarterly dividend payment of $1, it will open trading two days before the record date at a price of $30. This is known as the stock trading “ex-dividend”.
So if some dividends are good, more are better, right? Not so fast, although in my experience many investors believe this. As I always stress to clients, the way to compare any investment to another is by total rate of return, which is the sum of the dividends or interest received, and the price movement of the investment. While a stock that has an annual dividend yield of 8% may seem attractive, if the price declines 10% during the year, the total return for that year is -2%. It is not a coincidence that many stocks with eye-popping annual dividend yields are often mediocre investments, because their price tends to drift lower over time.
If you have the tolerance to own individual stocks, it is important to dig deeper than what the company’s annual dividend yield is. As your parents told you, if it seems too good to be true, it probably is.
David Novak, CFP® is a Certified Financial PlannerTM at Novak & Powell Financial Services in Pinellas County. Please note: he is not an attorney and this article should not be construed as one offering legal advice. For information about investment decisions and financial planning, email him at firstname.lastname@example.org.