In my last post I promised to shed some light on dividend-paying stocks and to explain the difference between interest and dividends. Simply stated, interest is what we earn on deposits when we’re putting money in banks, or the percentage fee we pay when we are taking money out in the form of a loan. Interest rates are quoted annually. Both deposits and borrowing are based on the “time value of money” and “compound interest”. Compound interest means that as our money grows and earns interest, that interest is added to our account, such that we now earn interest on the original amount we deposit PLUS that accumulated interest.
As a result of compound interest our money grows faster, similar to a snowball rolling down a hill, picking up additional snow and mass as it rolls, expanding its circumference. That’s a great analogy when thinking about investing your money and watching it grow. BUT if we are borrowing money compound interest is working against us. That snowball is rolling down the hill, but in the case of borrowing if we’re not careful it will roll right over us, crushing us in an avalanche of debt.
Dividends are the portion of profits companies return to their shareholders. Naturally, companies need to keep a portion of their profits as working capital in order to pay bills and allow for unforeseen emergencies. They also make sure to allocate funds to replace capital equipment, expand the business, and so on. But once those objectives have been met, many companies return the balance of the profits to the companies’ owners – the shareholders.
Dividends are generally paid quarterly, with an annual “yield” representing the return the shareholder receives as a percentage of his original investment. For example, if I bought a share of stock for $10 and the stock pays a $1 dividend ($.25 each quarter), I am receiving an annual return of 10% ($1 / $10 = 10%). But consider what happens if the stock price climbs to $20. Does the yield on my investment change? No, because the yield is calculated as a percentage of what I PAID for the stock originally, NOT what it is trading at today. Someone who buys the stock today at $20 would see a yield of 5% ($1 / $20 = 5%), provided the company continues to pay the same quarterly dividend.
Dividends differ from interest in several important ways. Your interest rate on a bank deposit is guaranteed, while dividends can be increased, decreased or discontinued at any time based on the company’s financial results or other business factors. Regarding taxes, interest income is taxed at your applicable personal income tax rate while dividends, at least according to current law, are taxed at a flat 15%. As always, our elected representatives like to tinker with taxation, so I expect we will hear a lively debate regarding the tax treatment for dividends as part of the upcoming election.
Dividend-paying stocks can be an important element in your investment portfolio. As always, that is a topic for discussion with a licensed investment professional. That discussion is sure to pay dividends… (sorry – I couldn’t help it!)