Dividend-Paying Vs. Non-Dividend Paying Stocks: What to Buy and Why

We live in an instant gratification world. We want our investments to generate returns now. We want cash flow now. We want the investment opportunities to give us the highest returns (profit) for the minimum risk we can manage. With stock market investing, there are 2 main ways to profit from directly owning stocks:

1. By buying and selling stocks (selling at a higher price than you bought, the difference being your profit)
2. Receiving a share of the profits from the company called dividends

Shares that pay dividends are better investment opportunities because they offer a "guaranteed" return every month, 3 or 6 months this making them somewhat "low risk".

How true is this?

When investors like you and me buy stocks of companies, we give those companies our money in the hopes that they would do business with it and make a profit. When they make profit, they can do 1 of 2 things.

1. They can reinvest all the profits they made back into the business to grow it OR
2. They can share some or all of the profits with the shareholders according to the number of shares they own (pay dividends)

How do companies decide which to do?

The goal of the management of every company has changed from profit maximization to shareholder wealth maximization

One of the questions every management team asks themselves when deciding when to pay dividends is, "Which option helps us better maximize shareholder's wealth?"

That is, "Can we make more money for our shareholders in the form of market growth (increase in share price) if we keep all the profits, i.e. not pay dividends to shareholders?" If yes, then they are better off reinvesting all the profits into the business. If the answer is no, then they should pay dividends.

However, this does not mean that every business that opts to keep its profits rather than share dividends will always turn the retained profits into more money for shareholders. This is where risk comes in.

When you invest in a company that decides to retain all its profits, you take the risk that its decision to reinvest its profits might not yield the positive result the management hoped for. If it does not yield positive results, this could cause the share price to reduce, thus putting the investment at a loss. If you do not want to take this risk, should you invest in companies that at least give investors some dividends? This brings us to the next question:

Are dividends guaranteed?

No.

Companies can reduce, suspend or permanently cancel dividend payments if they start experiencing financial difficulty. So, dividend-paying stocks do not help you avoid all risk either.

It is also important to note that even companies that pay dividends still have their share prices fall. An example of this would be General Electric (GE). While up to late 2018, GE paid decent dividends of more than 1% yield; since then, their dividends have been very low, and in that period, their stock price has seen more loss than growth. So common stock investors in a company like GE have likely lost on both fronts (dividends and capital appreciation).

If dividends are not guaranteed, and I can lose both ways, why should I even consider dividend stocks?

If you had invested in any tech company, say Apple, in 2011, you could have an average return of over 90% every year for 10 years. This data doesn't show/account for the fact that the average investor will likely NOT make these returns because they chase performance. When they see price dips, instead of buying more and implementing dollar-cost averaging, they panic sell, and then when they see the company recovering, they buy again. They buy high and sell low.

To make that return, you needed to have bought Apple stock and done nothing (except buy more) for 10 years. Most people can't, won't, and don't do that.

For investors like these, dividend stocks might be the solution. Instead of worrying about the daily movement in growth stocks that are often very volatile, they can focus on the regular dividends they would receive, albeit not guaranteed. This is one of the main appeals dividend-paying stocks have.

Owners can know that they could get something in the form of dividends at the end of this quarter. And if you invest in enough companies, you could even get dividends from a different company almost every day! On the trading app Trading 212, there is a pie that consists of stocks that, by investing in it, you could potentially get dividends paid almost every day. The name of this pie is "TheDividendExperiment". If you want to check this out for yourself, you can sign up to Trading 212 via this link to get a free stock worth up to ￡100 after you deposit funds into the account.

PS: Trading 212 only works for people with UK bank accounts.

Also, you can invest in an Exchange Traded Fund (ETF) that tracks dividend-paying stocks. That way, if one company stops paying dividends, the fund simply replaces that company with another company that pays dividends. An example of a dividend ETF would be OUSA ETF which has a dividend yield of around 2% per annum. More info about ETFs and how they work in a future article. Subscribe to this newsletter, so you get notified when that article is uploaded.

Let's go back a few paragraphs. Don't you find it interesting that most investors make less returns than the market? It reminds me of this quote.

Good investing is just as much of a growth game as it is a mind game

Common themes with dividend & non-dividend-paying stocks

Growth

"Companies that pay out dividends are mature companies while companies that retain all their profits are companies that still have high growth potential"

It is true in many cases that companies that don't pay dividends have high growth potential. Remember how management decides whether to pay out dividends. If management thinks they can grow investors' capital by reinvesting it in the business, they do that. For some mature companies like Walmart, which have little room for growth within their space, management opts to pay dividends instead. As such, there is very limited upside potential (in terms of increased share price) for dividend-paying stocks.

You sometimes find that with "growth companies", the share price could still increase even when the company is running at a loss. This is common with tech companies. People who invest in companies like these usually do it with the intention that the company would eventually become profitable and be worth a lot more so they can sell their shares for a much higher price because they bought in earlier. E.g. Amazon. But remember that potential is just that, potential. It doesn't always translate into reality. So investing in a company for the single reason that they don't pay dividends is not the way to go.

Remember, companies pay dividends out of profits, so even if the company has paid dividends in the past, note that there will be no dividends if the business runs at a loss. So, investing in a company simply because they pay dividends is also not the way to go.

Companies can increase the amount of dividends they pay. Chevron and Procter and Gamble are great examples of this. Also, you can seek out companies that pay higher dividends, but do this with caution because not all of those businesses can consistently afford to pay the dividends they promise.

Cash flow

"If it has no cash flow just say no" - Kevin O'Leary

If you invest in a company that does not pay dividends, you are buying into the idea that someone will be willing to buy that share from you at a higher price than what you bought it for. That idea may not always be true. If it turns out that no one is ever willing to buy the stock at a higher price, then you would lose a lot of money.

Whereas if you invest in a dividend-paying company, you can get regular passive income if it makes a profit.

Taxes

Taxes eat away at your dividend

When you receive dividends from a company, you must pay taxes on that received dividend. This tax rate depends on the country you are a tax resident in. Whereas, if you invest in a non-dividend-paying share, you don't have to pay taxes till you sell the shares at a profit. This consideration also depends on the country you are a tax resident in.

When thinking about taxes, think of it like this:

If you can keep more money by investing in a non-dividend-paying company in the long term after taxes are deducted than you would have if you invest in a dividend-paying company, then investing in a growth company might be a better option. Whereas, if you get to keep less money by doing that, then investing in a dividend-paying company might be better. You should consider the tax laws within your country or speak with a tax accountant to understand better.

How does this affect a Beginner Investor?

I think where young/new investors might get it wrong is when they expect to be able to live off their dividends. For example, if you invest $100 in the highest paying dividend stock currently, which offers a return of just about 8.75%, in ONE YEAR, the return for investing in that stock will be $8.75. I don't know about you, but I couldn't possibly imagine living on $8.75 for 1 year.

Even if you invest $1000, the return would be $87.5 in 1 year. Investing in dividend stocks starts making financial sense and paying off after you've invested consistently for years and reinvested your returns.

The only way you can live on dividend income is if you already have a large amount of money invested. Here's how you do the math.

How much do you spend in a year? Say $30,000

What is the best dividend stock you can get to last in the long run? Say one for 5%

To calculate how much you need to have invested to be able to live off dividends, calculate 30,000/5% (30,000 divided by 5%), which works out to be $600,000. So if you live on $30k a year and can find a stock that pays a 5% dividend yield every year, the only way you can live entirely on dividend income is if you have $600k invested in that stock. This means that you get more value from investing in dividends when you have more money invested. In the short term, if the amount you are starting with is not large, then it might not look like a very profitable venture, but in the long term, when compound interest takes place, it will add up.

Will you get more profit if you invest in a non-dividend-paying stock?

Not always. Some non-dividend-paying stocks end up growing a lot and making investors a lot of money, while others don’t. On the flip side, some dividend-paying stocks pay dividends that are so low, you would be better off leaving your money in a savings account. This differs from company to company. So, as said earlier, you need to look beyond the fact that a company pays dividends to determine if you should invest with them or not.

Final Thoughts

Dividend-paying companies are usually means to PRESERVE wealth while non-dividend-paying companies are means to GROW wealth

Younger investors look for companies with higher growth opportunities than those without growth opportunities because we often don't have enough capital needed to make dividend investing worthwhile in the short term. If you want to go fast, go with growth stocks. If you want to go far, while growth stocks can take you there in a shorter time, dividend stocks could be the way to go if you want a less bumpy road.