Dividends are corporate profits distributed to shareholders. Dividend decisions are based on a company’s profitability, growth prospects, investor expectations and stock price trends. Dividends often indicate a company's current profitability and growth prospects, and where it is in its life cycle.
Small, fast-growing companies usually do not pay dividends because they need to reinvest all the cash they generate back into the business. But no company can grow forever. As a company becomes bigger, its growth slows. Some companies continue to generate ample cash but no longer need all of it for the business, so they start paying out the surplus in dividends. Dividends might start small and increase over time as growth slows and the industry matures.
Many medium and large companies with limited growth prospects pay moderate dividends of between 1 percent and 3 percent. Companies in mature industries such as utilities, some financials and industrials pay generous dividends.
At any point during this cycle, a company might fail. If its profits shrink or it begins to lose money, a company cannot afford to pay dividends; its stock declines because of poor financial performance.
Many stocks that do not pay dividends represent small, fast-growing companies in leading economic sectors such as technology, the Internet and biotech, and are favored by aggressive investors and traders seeking capital appreciation. On the other end of the scale are companies that can’t afford to pay dividends because of falling profits or mounting losses. Non-dividend-paying stocks react strongly to earnings growth changes and prospects; many can be very volatile.
Many midsize and large companies are moderate growers that pay reasonable dividends -- typically in the range of 1 percent to 3 percent. Some increase dividends over time as their profits grow. Such stocks are favored by growth-and-income investors seeking moderate stock price appreciation and growing dividend income.
In addition to utilities, some financials and industrials, other sectors that pay generous dividends include real estate investment trusts, or REITs; oil and gas master limited partnerships, or MLPs; and oil and gas royalty trusts. REITS and oil and gas MLPs pay out most of their income in dividends by law. Oil and gas royalty trusts are conduits that pass to shareholders the income from mature oil and gas producing properties that they own.
Conservative income-oriented investors buy such stocks for high current income. High dividends tend to be an additional moderating factor on stock price: Investors who buy stocks for dividend income tend to step up their purchases when the price declines and the yield increases, and to curtail them when the price advances and the yield decreases.
- “One Up on Wall Street”; Peter Lynch; 2000