Have you invested in dividend-paying companies? If so have you ever thought of why do they give out dividends? Does the company you invested in pay out dividends because they have no other better use of their money or just to make shareholders happy?
First of all, we love dividends, I like dividends. Why? because dividends can give you a nearly consistent source of passive income which you can use to reinvest to buy more shares. But if you’re looking for the fastest return on investment, then you should rethink investing in dividend paying companies. Here’s why.
Dividends are paid out to investors when the company decides to pay out a part of its income. When a company generates a good profit, they could reinvest it back to the company as retained earnings or pay out dividends to shareholders. But what really drives growth to a company is retained earnings and when the company pays out dividends, they lower the retained earnings which in turn slows down future growth.
To easily understand this simple concept, if you received a 10,000 pesos worth of dividends, would you rather reinvest it or spend it on some nice little gadget? If you’re a smart investor, you would reinvest it back. The same is true with companies. If a company earns 25% return on capital, Do you think it would be wiser if the company reinvest it to have it compounded? Or rather pay it out as dividends which will also get taxed first before shareholders could get hold of it?
Warren Buffet didn’t pay out dividends on Berkshire Hathaway because he reinvest it back to buy more companies. To him, the only reason why a dividend should be paid out is if it has no other better use for the money that is retained.
If one of your investment goals is to have a steady source of passive income as you grow old, then dividend-paying companies is your choice. But if you want to focus more on growth potential, then you should be skeptical of dividend-paying companies. It really goes down to what investment goals you have.
If you decide to invest in dividend-paying companies, you should look through this few pointers:
- Look through reasonable payout ratios. Payout ratio is the amount of money that is paid out as a dividend as a percentage of net income. Check if the dividends are sustainable by looking at these ratios. Payout ratios that’s too high may not be sustainable in the long run.
- Check if the company has a long history of giving out dividends, and
- Check if the company is paying out dividends not just to make investors happy, but because it has no better use of the money earned.
For reference, click here to see a list of dividend-paying companies you may want to check to see if they are worth investing with.
Happy investing!