Dividends to Live Your Best Life - Money Meets Life (2024)

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Dividends are cash that is returned to shareholders from a companies profits. Investing in stocks, in essence, involves buying a piece of a business. What this means, is that the investor has “access” to the cash balance of the company. Dividends are one of the way in which value returns to the shareholder.

There are generally two types of shares: common and preferred shares. Preferred shares are named as such because they give “preference” to these shareholders and pay them first. Common shareholders, however, receive payment last.

This blog will discuss some of the costs and benefits of paying dividends. This topic can be very emotive to certain investors, so I will make every attempt to make my discussion as clear and objective as possible.

• Dividends: An Introduction
• The Psychological Benefit
• Personal Insights
• Dividends Irrelevance Theory
• Criticisms
• Dangers of Dividends
• Growing Profits and Revenues
• Payout Ratios
• What is the Optimal Ratio?
• A Sustainable Business Model
• Taxes
• How can you Avoid Dividend Taxes?
• Share Buybacks
• Conclusion

The Psychological Benefit

They offer a tangible reward amid the often patient and prolonged journey of investing.

Unlike the daily fluctuations in the stock market, where the ups and downs can be emotionally taxing, dividends act as periodic boosts, injecting a sense of achievement and satisfaction into the investor’s experience.

In the world of finance, the allure of dividends lies in their ability to provide a regular stream of income, creating a steady cash flow that investors can count on.

This consistent payout not only serves as a financial reward but also triggers a psychological response.

Receiving dividends is like regularly receiving a small dose of dopamine, a neurotransmitter associated with pleasure and reward in the brain. This consistent payout provides a sense of satisfaction and enjoyment for investors.

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.“

John D. Rockefeller

This infusion of dopamine is significant because it offers investors a positive reinforcement for their commitment to the long-term game of investing. It transforms the process from a long wait into a series of gratifying milestones.

These intermittent rewards can help to alleviate the stress and impatience that often accompany the volatility of the market.

Moreover, dividends give you a sense of financial stability. Knowing that a portion of the investment is generating regular income can instil a sense of security and control over one’s financial future. It becomes a tangible return on the faith an investor has placed in a particular stock or investment vehicle.

Personal Insights

From my own experience, I have found dividend stocks in my own portfolio motivating and I routinely track my returns on a monthly basis.

This process is liberating as I feel myself getting closer to financial freedom, and towards the point of being able to cover my daily expenses with dividends, and other investment cash flow.

Below is my current dividend income graph, which I maintain manually to record my progress:

I have also found that during downturns, dividend payers can allow you to reinvest dividends back into companies. This helps you own more of a company. You can also carry out this process automatically as most brokers have a DRIP (Dividend Reinvestment Plan).

Basically, your dividends are used to buy more of the shares which pay out the dividend. The DRIP gives you a chance to own more of a business without you involving yourself!

If you want to track your dividends month by month, download your free Google Sheet Dividend Tracker! I find that tracking your dividends with a Google or Excel sheet can really motivate a dividend investor to grow their dividend portfolio.

Dividends Irrelevance Theory

The dividend irrelevance theory, introduced by economists Franco Modigliani and Merton Miller in the 1960s, challenges the conventional wisdom that the payment of dividends significantly influences a company’s stock price.

At its core, this theory states that investors should be indifferent as to whether they receive returns in the form of dividends or through capital appreciation (stock price increase).

In essence, the value of a firm is determined by its earning potential and risk profile, rather than the specific method of distributing returns to shareholders.

The foundation of the dividend irrelevance theory rests on the concept of homemade dividends. If a company withholds dividends and chooses to reinvest earnings for growth or debt reduction, shareholders can create their own income by selling a portion of their shares.

This perspective suggests that the company’s decision to pay or not pay dividends does not alter the total return that investors can achieve.

Criticisms

However, critics of the theory argue that dividends indeed matter and can exert influence on a company’s stock price. They contend that dividends act as signals to investors. This provides valuable insights into a company’s financial health and future prospects.

A consistent and growing dividend payment may indicate that a company is not only profitable and stable, but also confident in its future earnings potential.

Consequently, investors may view such companies more favourably, leading to increased demand for their stocks and potential upward pressure on stock prices.

Dividends to Live Your Best Life

Moreover, some investors, particularly those focused on income generation, prefer receiving regular dividend payments as a source of income.

For them, dividends are not just a return on investment but a crucial component of their overall investment strategy.

Retirees in particular, who want the growth of stocks, yet also require regular income, can live off dividend income.

As a side note, I really enjoy watching Chuck Carnevale’s Fast Graphs YouTube channel for insights into how dividends provide income for retirement.

Companies that prioritise and sustain dividends might attract these income-seeking investors, influencing stock demand and, consequently, stock prices.

I definitely land on the side of the critics on this issue, as a company cutting a dividend, can have a direct effect on the share price, even if cutting the dividend could lead to greater growth.

Also, the whole theory rests on the idea that markets are efficient and rational, and it’s my belief that they are often emotional and irrational over the short term, yet more rational over the long term.

Dangers of Dividends

There is one main risk that every investor who invests in dividend companies needs to contend with.

This risk is whether the dividend is sustainable; can the business continue to pay the dividend, and will that payout be decreased overtime, or outright cut?

In order to mitigate against this risk, an investor should always assess:

• Whether a company has growing profits and revenues
• Whether the payout ration is usually high
• Whether there are fundamental risks to a company’s business model

Probably the most difficult to access is the third, as a business model’s sustainability can be difficult to judge.

Growing Profits and Revenues

Why are growing profits and revenues important for the dividend investor?

While the current yield influences investment decisions, the primary goal is to ensure that your money compounds, aiming for the best possible yield-on-cost. Achieving an optimal yield-on-cost is essential for long-term investment success.

For instance, Charlie Munger and Warren Buffett’s Berkshire Hathaway invested in Coca-Cola in 1988. That year, Coca-Cola paid 7.5 cents per share in dividends. The stock traded for approximately $2.50 per share after adjusting for stock splits along the way.

That means that the yield at the time was around 3%. As co*ke Cola was able to raise their dividend every year, Buffett’s yield-on-cost on co*ke is 57% . For me, this is one of the most exciting prospects in dividend investing. I imagine that in 10 years, some of my dividend companies will be paying out significantly higher dividend compared to my cost basis.

However, it was only the fact that Buffett invested in a business that was effective at growing its revenues and profits that allowed the dividend to increase so regularly.

Payout Ratios

The payout ratio for dividends is a simple financial metric that indicates the percentage of a company’s earnings that is paid out to shareholders in the form of dividends. It is calculated by dividing the total amount of dividends distributed by the company by its net income.

In basic terms, if a company has a payout ratio of 30%, it means that 30% of its earnings are being returned to shareholders as dividends. The remaining 70% is retained by the company for reinvestment, debt reduction, or other financial needs.

What is the Optimal Ratio?

A higher payout ratio suggests that a larger portion of the company’s profits is being distributed to shareholders, leaving less for the company to reinvest in its operations or address financial obligations.

On the other hand, a lower payout ratio indicates that the company retains a larger share of its earnings, potentially for future growth initiatives or to strengthen its financial position.

Investors often consider the payout ratio when assessing the sustainability of a company’s dividend payments. A very high payout ratio might indicate that the company is distributing more than it can afford. Conversely, a low ratio might suggest that the company is not sharing enough of its profits with shareholders.

The optimal payout ratio can vary by industry and depends on the company’s specific circ*mstances and growth opportunities. I typically, however, try to look for companies with low payout ratios.

A Sustainable Business Model

Nortel Networks Corporation, a Canadian telecommunications equipment manufacturer, thrived during the late 1990s dot-com boom but faced a downturn as the bubble burst in the early 2000s. Struggling with declining demand and an accounting scandal in 2004, Nortel filed for bankruptcy in 2009.

The bankruptcy marked the end of Nortel’s prominence, leading to the auction of its assets to repay creditors. The story of Nortel serves as a cautionary tale about the impact of economic downturns, technological changes, and corporate mismanagement on major industry players.

Nortel, actually paid a dividend, but who would have thought that such a dominant company would go out of business?

What this reveals is that it can be extremely challenging to identify what factors doom a company. It can, therefore, be difficult to tell if a dividend is sustainable.

The Dividend Snowball

The effect of investing in reasonably-priced companies offering stable dividends, and a steady rate of growth, is that your dividends can snowball. This dividend snowball is one of the most powerful features in the investment world.

The “dividend snowball” is the compounding effect when investors reinvest dividends, leading to a growing income stream. In other words, Money attracts Money. Here’s a simplified example:

1. Initial Investment: You invest £1,000 in a stock with a 4% dividend yield, receiving $40 in dividends annually.
2. Reinvestment: Instead of cashing out the £40, you use it to buy more shares of the same stock.
3. Compounding: With the reinvested dividends, your total investment grows. Next year, the 4% yield applies to the larger investment, resulting in a higher dividend.
4. Example: If the stock grows by 5%, your £1,000 investment becomes $1,050. The 4% yield now gives you $42 in dividends, and you reinvest again.
5. Snowball Effect: Over time, as dividends are reinvested and the investment grows, the income stream increases. The compounding effect accelerates, creating a self-reinforcing cycle.

This strategy works best with stable dividend-paying stocks that experience steady growth, allowing the snowball to gain momentum over the long term.

Taxes

Owning dividend stocks can be a valuable source of income for investors, but it’s important to consider the associated tax implications. While dividends provide a steady stream of cash for investors, they also come with certain disadvantages from a tax perspective.

Regular dividends are generally taxed as ordinary income, subjecting the earnings to the same tax rates as wages or interest income. Unlike qualified dividends, which benefit from a more favourable capital gains tax rate, regular dividends lack such preferential treatment.

This can result in a higher tax liability, particularly for high-income earners who may face increased tax rates.

Even if investors reinvest their dividends, the reinvested dividends are still taxable income. Holding dividend-paying stocks in taxable accounts can reduce tax efficiency, eroding returns, especially for those in higher tax brackets.

How can you Avoid Dividend Taxes?

To prevent the harmful effect of these taxes on your investment growth, investors can consider holding dividend-paying stocks in tax-exempt accounts. These include the Roth IRA (in the US), where dividends are not subject to current taxation, providing a shield against immediate tax liabilities.

Understanding the differences between regular and qualified dividends, along with utilising tax-advantaged accounts, can help investors manage and minimise the tax impact of their dividend income.

Personally, as I am UK based, I hold my dividend stocks in an ISA and the Lifetime ISA, or LISA, as dividend payments are not taxed. In fact, I would recommend always holding your dividend stocks in a tax efficient account rather than be liable for the tax.

There is also usually a dividend allowance available, which means that you can receive a certain amount in dividends before you have to pay tax.

Buffett receives a hefty share of dividend income into his portfolio year after a year. Despite this, he believes, and I agree, that if a business is selling at a low valuation, the best course of action is to buy back more shares.

If investing back into the business yields a sub-par return, then buying back shares is the most efficient use of extra cash. This way, a company can reward shareholders with a bigger share of the business.

Unfortunately, many companies do not vary their dividend policy or rate of buybacks depending on the market-cap and value of the company. This is probably because although company management usually wants to sweeten the deal for shareholders, they are more concerned with popularity.

Short term popularity tends to be the main concern for company management, and not the long term returns for shareholders.

“We’d rather have a company whose stock is undervalued buying back stock but the trouble is if you pay a dividend you’re not going to eliminate it,”

Buffett

Conclusion

So, as you step away from this discussion, think of dividends as your portfolio’s reliable companion. They bringing stability to your portfolio (especially in downturns). Furthermore, they can be a source of comfort on a long road.

Certainly in my personal life, I have found that dividend returns provide an excellent incentive for me to continue contributing to my investments. I also get a lot of enjoyment from keeping records of the growth of my income over time.

Here’s to making smart moves, crafting your financial playlist, and letting dividends contribute to your financial success. Happy investing!

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