How dividend payments can augment your income
Dividend payments generated by ownership of company stock have been in existence since the first informal group of investors pooled their resources to start a company.
The formal definition of a dividend is a cash distribution from company earnings to common and preferred stock equity shareholders.
Company management and the board of directors must decide annually, if and, how much of a dividend to declare. The dividend policy determines the portion of the firms earnings to be paid out to their shareholders — otherwise known as the payout ratio — and how much to retain on the balance sheet for expansion, competition, innovation and research. Whatever the schedule, millions of shareholders invest in public (and private) dividend paying equity firms to augment their income.
Cash outflows: Generally, a smaller private company does not (or cannot) pay a dividend. All shareholder equity contributions are needed to fund the company during its inception phase. Start-up corporate expenses can be high and immediate while the business model may take several years to turn a decent profit. At a later time then, with comfort cash banked for contingencies, the company can safely implement a dividend return policy for its shareholders. The dividend payment plan can be scaled in additional shares, or cash. Additional shares dilute total company ownership while cash dividends deplete company reserves.
Legacy dividends, investor perception, and effect on the company. Investors in publicly traded company shares may feel entitled to additional cash flows — dividend payments — even though their relationship to the company is far removed from the original shareholders. In fact, once the company shares offered in secondary markets, the company itself derives little profits from the appreciation (loss) in these securities transactions. Legacy shares passed down several generations may represent an initial investment of say $2 per share, where the value is now trading at $40 per share. The original contribution to the start-up company has long been spent, yet the company continues to reward these investors. Of course, it can be argued that the original investment, when inflated, may realise an equal investment in todays dollars.
A dividend is not a God-given right. Most shareholders may not realise that dividends might not be paid in a difficult year. Times change; the world has changed; global competition is here to stay. Companies are no longer reluctant to cut their dividends — or eliminate them altogether. They may do so more frequently in a competitive market; the better able to use their retained capital to reinvest in capital improvements or increase market share.
Noticeably absent from the definition of a dividend is the word regular. A companys management position may be that all profits are needed for growth and expansion with the investor being rewarded by long-term stock price appreciation. Warren Buffett, CEO of Berkshire Hathaway does not believe in dividends. Bill Gates company Microsoft accumulated more than $40 billion in free cash, before the company paid a first dividend to shareholders. Apple, after 17 years without a dividend payment, will start to remit some profits to shareholders from next month. Still, thousands more global publicly traded companies have had a long history of paying dividends, among them Coca-Cola (1893), Exxon Mobil (1882) and General Electric (1899).
Many local Bermuda investors from multiple generations felt comfortable holding domestic stocks. They knew these companies; they grew up as these companies grew up. However, familiarity with local stock is not the same as venturing into global investment markets. In the years since the amalgamation of one local bank and the global market impact on another, there have no doubt been many discussions (and hardships) among local shareholders centred on the elimination of the previously comfortable dividend payments.
Dividend payment trends for S&P 500 2012, for reference, have crept up a bit since last year, averaging around a two percent return. Still the dividend yield for many companies is low and will remain so until recessionary pressures subside.
Chasing a dividend yield? The United States five- and ten-year maturity Treasury Notes — perceived to be the safest currency in world — are yielding very little, a tiny 0.75 percent and 1.63 percent interest yield respectively on an annualised basis (Bloomberg, June 28, 2012).
Other types of investments paying higher yields always raise interest and questions. Number one being, how can a company or government afford to pay a four percent, six percent, or higher rate of return? The second most serious question is, will I get my original investment back whether Ive invested in stock or in bonds?
For the risk of a high dividend yield, there is a price. Investors, who fixate only on a high dividend yield, may fail to understand the risks inherent in owning a concentrated portfolio of, say, only preferred equity positions.
Both common and preferred stocks are susceptible to market volatility that can be driven by both a public companys internal financial position as well as external current economic conditions. US companies issued preferred shares, for instance, considered relatively stable during expansionary capital markets, even in their constrained investment spectrum suffered unrealised share devaluations (if they were not sold) in the 2008 downturn.
During that time, Lehman Brothers preferred shares saw their market value (and dividend payouts) slashed to zero. In a matter of days during the largest financial institutional collapse in history, 26,000 Lehman employees lost their jobs.
Balancing risk versus reward. Whenever, an investor considers investing a large of sum of money, and for each of us, large has a different connotation, take the time for deliberate thought. And by the way, your pension may represent a large sum of your invested cash.
Use the power of the internet to learn about investments: three websites to start with are listed below.
There are thousands of investment books out there also: purchase a basic finance book and enter this new and incredibly interesting world.
Learn To Earn (1995), One Up On Wall Street (1989) or Beating The Street (1994) by Peter Lynch — still a fabulous set of easy to read investment concepts, and How To Make Money In Stocks (2003, third edition) by William J ONeil
For an explanation of the differences between common and preferred shares, go to http://www.investopedia.com/terms/c/commonstock.asp#axzz1zAnkPPmy
Martha Harris Myron CPA PFS CFP (USA) TEP is Director of Tax Services, and a cross border financial planning specialist at Patterson Partners Ltd as well as a member of the American Citizens Abroad Professional Tax Advisory Council. http://www.aca.ch Patterson Partners Ltd. provides integrated cross-border tax, estate, investment advisory and related strategic planning services through entities in Bermuda and the United States. For additional information, please contact firstname.lastname@example.org or call 296 3528 http://www.patterson-partners.com
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