Investors should never underestimate the power of dividends.
Stock prices, of course, tend to rise over time. The Dow Jones Industrial Average
was at about 70 a century ago. It cracked 35,000 in July 2021. That works out to an average annual return of about a little more than 6%.
But stocks, over that span, have returned a total of about 10% a year on average. The other 4% came from dividends. That’s roughly 40% of the total return. Dividends are a big portion of long-term stock returns.
That 4% of return only comes if you reinvest the dividends paid by the company over time, buying more shares with all the regular payments. Investors don’t have to reinvest dividends, though. They can spend them, which isn’t a bad thing either.
Company’s pay dividends, essentially, because they are returning some of their cash flow to the company’s owners — that is, all the individual stockholders. But they also pay dividends because they don’t have anything better to do with the cash. They have cash leftover after covering the costs of running the business and investing for future growth by, say, building plants or conducting research.
Dividend payments also relay important information about companies and stocks.
If a company has a relatively high dividend yield — that is, its annual dividend payment divided by its stock price — investors often think of it as a riskier or slower growth company. (For comparison, the dividend yield on the S&P 500 is about 1.4% these days.)
And when a company cuts its dividend it’s a very bad sign. It says that management is worried about cash flow.
Dividends are a wonder, and we’ll explain more in the video. But first, test your dividend knowledge:
How long after it was founded did Microsoft begin paying a dividend? For the answer and more, watch this video.