Five of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, they provide an extra metric for fundamental analysis, they reduce overall portfolio risk, they offer tax advantages, and they help to preserve purchasing power of capital.
Growth and Expansion of Profits
One of the primary benefits of investing in dividend-paying companies is dividends tend to steadily grow over time. Well-established companies that pay dividends typically increase their dividend payouts from year to year. There are a number of "dividend aristocrats," or companies that have continuously increased their dividend payouts for more than 25 years consecutively. Since 1980, the dividend average compounded annual growth rate for S&P 500 companies that offer dividends has been 3.2%.
One of the basics of stock market investing is market risk, or the inherent risk associated with any equity investment. Stocks may go up or down, and there is no guarantee they increase in value, but while investing in dividend-paying companies is not guaranteed to be profitable, dividend stocks offer at least a partial return on investment that is virtually guaranteed. It is very rare for dividend-paying companies to ever stop paying dividends, and in fact, most of these companies increase the amount of their dividends over time.
Many investors fail to appreciate the huge impact dividends have on stock market profits. Since 1926, dividends have accounted for almost half of stock investing profits in the companies that make up the S&P 500 Index. This means the inclusion of dividend payments has roughly doubled what stock investors have realized in returns on investment as compared to what their returns would have been without dividend payments.
Additionally, in this low-interest-rate environment, the dividend yield offered by dividend-paying companies is substantially higher than rates available to investors in most fixed-income investments such as government bonds.
Dividends Are Helpful in Equity Evaluation
Just as the impact of dividends on total return on investment, or ROI, is often overlooked by investors, so too is the fact that dividends provide a helpful point of analysis in equity evaluation and stock selection. Evaluation of stocks using dividends is often a more reliable equity evaluation measure than many other more commonly used metrics such as the price-to-earnings, or P/E ratio. Most financial metrics used by analysts and investors in stock analysis are dependent on figures obtained from companies' financial statements. The potential problem with evaluating stocks solely based on a company's financial statements is companies can, and unfortunately sometimes do, manipulate their financial statements through accounting practices to improve their appearance to investors. Dividends, however, offer a solid indication of whether a company is performing well. In short, a company has to have real cash flow to make a dividend payment.
Examining a company's current and historical dividend payout gives investors a firm reference point in basic fundamental analysis of the strength of a company. Dividends provide continuous, year-to-year indications of a company's growth and profitability, outside of whatever up-and-down movements may occur in the company's stock price over the course of a year. A company consistently increasing its dividend payments over time is a clear indication of a company that is steadily generating profits and is less likely to have its basic financial health threatened by temporary market or economic downturns.
An additional benefit of using dividends in evaluating a company is that since dividends only change once a year, they provide a much more stable point of analysis than metrics that are subject to the day-to-day fluctuations in stock price.
Reducing Risk and Volatility
Dividends are a major factor in reducing overall portfolio risk and volatility. In terms of reducing risk, dividend payments mitigate any losses that occur from a decline in stock price. But the risk reduction benefit of dividends goes beyond that basic fact. Studies have consistently shown that dividend-paying stocks significantly outperform nondividend-paying stocks during bear market periods. While an overall downmarket generally drags down stocks across the board, dividend-paying stocks usually suffer significantly less decline in value than nondividend-paying stocks. A stark example of this fact was displayed during the overall market downturn in 2002, when nondividend-paying stocks fell by an average of 30%, while dividend-paying stocks only declined on average by 10%. Even during the severe 2008 financial crisis that precipitated a sharp fall in stock prices, dividend stocks held up noticeably better than nondividend stocks.
Owning stocks of dividend-paying companies also substantially reduces overall portfolio volatility. A 2000-2010 comparison of dividend-paying companies versus nondividend-paying companies in the S&P 500 Index shows a marked contrast in levels of volatility. The beta of dividend-paying companies over this period of time was 0.98, slightly less than the overall market average. The beta of nondividend-paying companies for the same time period was 1.48, showing a much higher volatility rate than the overall market average.
Dividends Offer Tax Advantages
The way dividends are treated in regard to taxes makes dividends a very tax-efficient means of obtaining income. Qualified dividends are taxed at substantially lower rates than ordinary income. Per IRS regulations as of 2011, for individuals whose ordinary income tax rate is 25% or higher, qualified dividends are taxed at only a 15% rate. And for individuals whose ordinary income tax rate is below 25%, qualified dividends are completely tax-free.
Dividends Preserve Purchasing Power of Capital
Dividends also help out in another area that investors sometimes fail to consider: the effect of inflation on investment returns. For an investor to realize any genuine net gain from an investment, the investment must first provide enough of a return to overcome the loss of purchasing power that results from inflation. If an investor owns a stock that increases in price 3% over the course of a year, but inflation is at 4%, then in terms of the purchasing power of his capital, the investor has actually suffered a 1% loss. However, if that same stock that increased 3% in price also offers a 3% dividend yield, the investment has successfully returned a profit that outpaces inflation and represents an actual gain in purchasing power for the investor. The good news for investors in dividend-paying companies is that many dividend yields outpace inflation.