Not only do dividends provide necessary income for many investors, they also serve to reduce portfolio volatility (risk), can result in tax advantages, and also provide a stream of growing income.  

Understanding Dividends

Dividends are cash payments paid by companies to their shareholders. Although dividends may sound rather ordinary, they comprise a large portion of total investment returns. The total return on your investments consists of two components:  Dividends and Price Growth.

Lowering Risk

Not only do dividends help to drive the returns of an investment portfolio, they also serve to mitigate the risk that investors are exposed to. Dividend paying stocks, on average, exhibit less price volatility (risk) than non dividend paying stocks.  This reduced risk comes from cash flow payouts in the near-term, which the market recognizes as lowering uncertainty.

Another way of looking at dividend related risk reduction is through the idea of price support.  If the price of a dividend paying stock falls beyond a “reasonable” level the market will begin to purchase the now “cheap” dividend payment stream.  This in turn increases the stock price.  This process effectively supports the price of a dividend paying stock from falling too far, and should hold as long as the underlying company’s ability to pay its dividend is maintained.

Tax Advantaged Income

In Canada, dividend income from stocks is taxed at a lower rate than income from bonds, income trusts, and GICs. Currently, $1 of stock dividend income is approx-imately equivalent to $1.50 of interest income from a bond^[1].   If your unique tax situation allows you to benefit from receiving dividend income as opposed to other security income, your portfolio should be adjusted to take advantage of these opportunities.

A Rising Income Stream

Dividends, as opposed to most fixed-income investments, are expected to rise over time at least as much as the rate of inflation.  Over the long term, these rising dividend payments help preserve the purchasing power of your portfolio indefinitely.  This makes them an ideal portfolio component along with fixed income investments.  

Dividend Payback

Dividend payback is the amount of time it takes for a stock to pay for itself through its dividend.  Royal Bank had steadily grown its dividend from $0.05 per share in 1965 to $2.00 in 2010, for an average compounded growth rate of almost 8.5%.  To see an example of how profitable dividend payback can be, consider a scenario where an investor purchases Royal Bank shares today at $50 each.

Going forward, if we assume an 8.5% growth rate for the dividend, and no price growth at all, the Royal Bank dividends would pay back the investor their entire initial $50 investment within year 14. 

Dividends Enforce Discipline

Dividends encourage management to be financially responsible. Conversely, irresponsible companies such as those that excessively distribute stock options to executives or tend to issue shares repeatedly for the purposes of raising capital get penalized for doing so where dividend payers are concerned.  As the number of outstanding shares increases, so does the firm’s total dividend obligation.

In addition, one of the hallmarks of a “good” company is the ability to pay steady and growing dividends over the long-term. This signals the company has been able to generate cash flow above its expenses even during market downturns and recessions.

A Blue-Chip Example

Dividend paying companies exist across many industries.  McDonald’s Corp is an example of a company with a history of consistent and strong dividend growth.  Over the last few years, McDonald’s dividend increased from $0.23/share in 2002 to almost $2.2/share in 2010.

As a result, if an investor purchased shares of McDonald’s in 2002 at the then market price of $16, her current dividend yield on her McDonald’s investment is over 13.5% per year from the initial purchase price.  In other words, for every 100 dollars invested in McDonald’s in 2002, $13.5 per year are paid to the investor going forward.  This ongoing dividend payment does not include any future growth in the dividend or appreciation of the actual stock price (conversely it also does not reflect future dividend cuts or drops in stock prices).

Caution: Avoiding the Yield Trap

One common mistake for dividend-seeking investors is only choosing companies with high dividend yields.  In fact, companies sporting a high dividend yield often cannot sustain them, particularly if the high yield is due to a declining share price.

It is important to look for key factors such as free cash flow (the ability of a company to generate cash after expenses), and the dividend payout ratio (the percentage of its earnings must be paid out as a dividend), to help determine if a company can maintain and even improve its ability to reward its shareholders.