I’ve discussed the most obvious benefits of dividends before. We know that dividends are a fantastic source of passive income and that over time, dividend growth stocks can become cash cows. We also know that dividends provide compounding power and that they often make up the bulk of total stock market returns. These are significant benefits.
However, the benefits of dividends don’t stop there. Today, I’m exploring some other key benefits of dividends that are often overlooked.
Evidence of financial strength
A dividend payment is a signal of financial strength. This is due to the fact that cash is required to make a dividend payment. Financially-troubled companies often don’t have the resources (cash) available to reward investors with regular dividends. If a company pays you a dividend, it’s generally a signal that the company is in healthy shape and generating decent cash flow.
Evidence of shareholder interest
Furthermore, when a company pays a dividend to its shareholders, it’s showing a direct interest in these shareholders. From an investor point of view, that’s a huge positive.
Consider two companies – SSE (LON: SSE) and Sports Direct (LON: SPD).
SSE states on its website:
“We believe that our first responsibility to shareholders is to give them a return on their investment through the payment of dividends.”
As a part-owner of a company, that’s exactly what you want to hear.
In contrast, Sports Direct does not pay its shareholders any dividends. That signals that management has little regard for the shareholders. Which company would you rather be a part-owner of?
Corporate self discipline
Dividends also keep management in check and prevent funds being wasted on mediocre acquisitions or projects.
Consider a company that generates a profit of £10 million. It has two investment opportunities available, one that has a potential return on equity of 24% and one that has a potential return on equity of 7%. Each investment opportunity would require an investment of £5 million.
If the company has no dividend commitments, it may go ahead and make both investments, even though the return on offer from the second investment looks a little underwhelming and is probably not the best use of capital.
However, if the company has a £5 million dividend to pay out, it has to use its funds wisely. Therefore, there’s less chance of the cash being blown on an average investment opportunity.
Lastly, companies that pay consistent dividends generally attract a better class of shareholder.
I’m talking about patient, long-term investors that are onboard for the long haul. This includes both private investors and institutional asset managers. These types of investors are likely to be more rational, and less likely to overreact to short-term difficulties.
In contrast, when you have a stock that is all about fast share price gains, it’s likely you’ll have many short-term shareholders who treat the stock like a lottery ticket. This can result in wild share price fluctuations and large sell-offs during times of difficulty. Would you rather own a stock that has a fairly constant share price and rewards you with regular cash payments or a stock that flies up and down like a yo-yo? I know what I’d rather own.
Edward Sheldon, CFA has no position in any shares mentioned.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.