The answer illuminates why dividend investing continues to attract new adherents.
Simply put, dividend investors realize that investments should pay you real money. Too often, people approach the stock market as the world’s largest virtual casino.
The World’s Largest Virtual Casino
It is very easy to think of each stock ticker as a virtual bet. Sometimes, the price rises, and sometimes it falls. It all feels so random. It is the same feeling you get in Las Vegas… You either get lucky and win money, or you don’t.
Stocks are much more than virtual lottery tickets.
Buying a share of stock entitles the investor to a fractional share of ownership of a business. When you buy a stock, you are investing in a real-world business.
Business and gambling are very different. Businesses earn money when they provide services or products that their customers are happy to purchase. If a business is run well, it will continue to grow larger. If it is run poorly, it will eventually decline.
Notice the stark difference between business and gambling. In business, success depends on serving your customers better or more efficiently than your competitors. Sure, there is some luck involved, but intelligence and hard work will lead to favorable results.
Gambling is completely different (this does not include games played against other people instead of the house, like poker). The odds in gambling are set. You will lose over time. There is no amount of skill that can make someone a winner playing slots or roulette. You will lose if you play long enough. The house always wins.
The stock market is not a large casino, even though many investors treat it that way. The stock market allows people to purchase small percentages of the world’s greatest companies (or mediocre companies, if you want).
Dividend-Paying Businesses
At this point, hopefully, readers see the difference between buying random stock tickers and investing in sound businesses to take advantage of their attractive economic prospects.
Dividend-paying businesses are different than non-dividend-paying businesses. First, for a business to pay a dividend for any lengthy amount of time it must be profitable. Businesses that lose money simply cannot pay dividends for any meaningful length of time. Unprofitable businesses will run out of money and declare bankruptcy faster by paying dividends.
Profitable businesses, on the other hand, can return profits to their owners by paying dividends. A dividend payment is the return of profits to the owners of a business. As a shareholder, you are an owner.
Take Coca-Cola (KO) as an example. Coca-Cola pays out 64% of its earnings as dividends. Every time someone buys a Coke, Coca-Cola shareholders get 64% of the profits paid to them.
You may be wondering, what happens to the other 36% of Coca-Cola’s earnings? If shareholders own the company, why aren’t 100% of earnings paid out to shareholders as dividends?
The reason Coca-Cola does not payout 100% of its earnings as dividends is that the company’s management attempts to maximize the long-term value of Coca-Cola shares.
To do this, Coca-Cola needs to grow. Coca-Cola’s managers have estimated that the optimal amount of profits to reinvest in the business is around 36%. This money goes to repurchasing shares, building up cash balances for stability, repaying debt, and investing in future growth.
Coca-Cola is expecting earnings-per-share growth of 7% to 9% a year. The company will likely grow dividends at around the same rate.
If Coca-Cola paid out 100% of its earnings as dividends, it would have a yield of 5.1%. Coca-Cola stock currently has a yield of 3.3% and is expected to grow at 7% to 9% a year. In 10 years, Coca-Cola shareholders will have a yield on cost of around 7.1% thanks to growth. If the company paid out all of its dividends and reinvested nothing in growth, shareholders would be worse off in 10 years than if Coca-Cola does reinvest some of its earnings for future growth.
Why Invest for Dividend Income?
Investing for dividend income places focus on what matters in investing – a businesses’ ability to generate growing income over time. Dividend investors look for businesses that will be able to pay increasing dividends because the business is growing its income.
This eliminates unprofitable businesses from consideration for dividend investors. Avoiding the worst businesses is certainly a good start in not losing money investing. If you aren’t losing money, you will end up making money.
Dividend-paying businesses also produce passive income. Dividends roll in each month or quarter, without you doing a thing. Over time, this passive income stream will grow as the businesses grow, and as you invest additional money. This ‘snowball effect’ results in a compound growth of passive income.
The ultimate goal of dividend investing is to be able to live off the passive dividend income your portfolio generates. The speed at which a dividend investor reaches this goal depends on a few key variables:
- What your monthly expenses are (the lower, the better)
- How much you save every month (not how much you make)
- How quickly your dividend income grows
Why invest in dividend income? Because you will build a growing, passive stream of income while focusing on what makes investments successful.
Source:http://www.talkmarkets.com/content/us-markets/why-invest-for-dividend-income?post=67248
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