10 Common Misconceptions about Dividends

By Lawrence Carrel

Stock market investors and analysts often take sides on the issue of investing in dividend stocks. Here, the ten most common myths and misconceptions about investing in dividend stocks are busted to provide you with a more balanced view.

Dividend investing is only for old, retired folks

Dividend investing is admittedly attractive for seniors, whose goals are typically capital preservation and income. Younger investors, however, can also benefit from a dividend investing model, even if it comprises only a portion of their portfolios.

Although seniors may want to stick with large, well-established corporations, younger investors may want to aim more toward the middle to lower end of the dividend spectrum. Younger investors wanting growth stocks should buy up-and-coming companies that are established enough to pay small dividends but demonstrate that they still have plenty of growth potential (in both capital appreciation and dividend payments).

You can get better returns with growth stocks

Although growth stocks may offer more in terms of share price appreciation, dividend stocks often make up the difference in dividend payments. Dividend stocks can see returns grow in three ways:

  • Share prices can rise.

  • Dividend payments can increase.

  • Reinvested dividends can purchase more stock.

When comparing growth and dividend stocks, compare their potential in terms of total return on investment. For the dividend stock, this means share price appreciation plus dividends.

Sometimes, slow and steady really does win the race. Growth stocks may carry a higher potential for bigger returns, but they also carry a higher risk for bigger losses. If you do experience a loss, your other holdings need to perform that much better to make up the difference.

Dividend stocks are safe investments

Investing is risky no matter how you slice it; the risk of losing money is always present. However, some investments, including dividend stocks, tend to be safer than others.

Don’t put all your investment eggs in one basket. Even when investing in safer options, diversify to spread the risk among several sectors and among companies in the various industries you choose to invest in.

Companies limit their growth by paying dividends

Growth investors often argue that companies paying dividends would be better off reinvesting that money to fuel their growth. Although this suggestion may be the case with some companies in certain situations, the reasoning is valid only if that money is well spent.

Companies that don’t pay dividends give managers unrestricted use of the profits. Corporate executives often make acquisitions or start projects more to boost their personal worth (through bonuses and reputation) than to boost shareholder value. Risky acquisitions outside the company’s main business often promise big results and just as often turn into money pits. Meanwhile, a commitment to paying dividends keeps management honest. Knowing the company must generate a certain amount of cash flow per quarter to pay the dividends shareholders expect tends to motivate management to manage effectively. In addition, paying dividends leaves management with less capital to squander on risky business ventures. As a result, management must evaluate prospective business ventures more carefully.

Paying down debt always comes before paying dividends

Debt isn’t necessarily a bad thing, although excessive debt certainly is. Whether a company should pay down debt before cutting dividend checks depends on the circumstances. If the company is buried in debt and struggling in a tough economy, paying down debt before paying dividends is not only a good idea but also an essential move to protect the company’s survival. If, on the other hand, the company carries a reasonable debt load and its other fundamentals are solid, continuing or even raising dividend payments sends a positive message to the market.

Before purchasing a dividend stock, carefully inspect the company’s quarterly reports and take a close look at the quick ratio. The quick ratio indicates whether the company’s current assets are sufficient to cover its liabilities. The break-even point is a quick ratio of one, which usually means the company can afford to cover its liabilities, including its declared dividend payout. Anything less than one may mean that the company needs to borrow money to pay dividends, which is a bad sign.

Companies must maintain a stable dividend payout

Companies are not obligated to pay dividends or to keep the payment stable after they start. However, dividend cuts tend to reflect poorly on a company and its share price, so companies tend to be conservative in establishing a dividend policy. Companies protect themselves by choosing a dividend payment method that allows them to manage shareholder expectations:

  • Residual: With the residual approach, the company funds any new projects out of equity it generates internally and pays dividends only after meeting the capital requirements of these projects.

  • Stability: A stability approach sets the dividend at a fixed number, typically a fraction of quarterly or annual earnings, called a payout ratio. This gives investors a greater level of certainty that they’ll receive a dividend and how much it’s likely to be.

  • Hybrid: The hybrid approach is a combination of the residual and stability approaches. Companies that follow this approach tend to set a low, fixed dividend that they feel is easy to sustain and then distribute additional dividends when they can afford to do so.

Dividend increases won’t even keep up with inflation

Some companies’ dividend increases do in fact fail to keep pace with inflation. Your goal as a dividend investor is to ensure that the dividend payments from companies you invest in at least keep up with inflation and hopefully exceed the inflation rate.

If you’re a growth investor looking for income, don’t dump a stock just because dividend payments aren’t keeping pace with inflation. Look at the stock’s total return, including share price appreciation, and continue to monitor the company’s fundamentals and the market at large. If the company is doing well, especially in a tough market, it may have the potential to raise dividend payments sometime in the future and perform well for you.

All dividends are taxed at the same rate

Dividend investing fell out of favor in the 20th century because of unfavorable dividend taxation. A major reason for the resurgence of dividend investing was the lowering of the tax rate on dividends. The catch is that not all stocks qualify for the lower tax rate. To qualify, you have to hold the stock in your portfolio for at least 61 consecutive days during the 121-day period that begins 60 days before the ex-dividend date. Dividends that fail to qualify get taxed at the investor’s regular tax rate. (One exception is master limited partnerships, which pass all their tax liabilities back to investors.)

You should always invest in high-yield stocks

Don’t judge a stock by yield alone. Yield is a valuable measure of how much bang you’re getting for each of your investment bucks, but it alone doesn’t determine a stock’s true value; you also need to look at the share price. You can use a minimum yield to screen out stocks that don’t meet your income requirements, but carefully evaluate a company’s fundamentals before investing in it.

A high yield can mean many things — some positive, some negative. High yield may be a sign that the company’s share price is sinking and that the company may be in trouble. If the high yield is out of whack with its sector, that may be a sign of an impending dividend cut. By the same token, don’t immediately write off low-yield stocks.

REITs and bank stocks are no longer good for dividends

Two major factors that contributed to the fiscal crisis of 2008–2009 were a housing bubble that pushed the prices of real estate properties to astronomical heights and banks that approved mortgage loans for borrowers who couldn’t afford the payments. Not surprisingly, real estate investment trusts (REITS) and bank stocks, traditionally big dividend payers, were some of the hardest hit in the stock market crash of 2008–2009. With little cash to pay their obligations, many REITs and banks were forced to cut or eliminate their dividends.

However, a few strong companies continued to pay out dividends and even raised payments because they took less risk and managed their debt well. Don’t write off all these companies in one fell swoop. Many have cleaned up their balance sheets and reinstated dividends.