Dividends are cash payments a corporation regularly makes to its shareholders. Such payments are approved by the firm's board of directors and can be paid once, twice or four times a year. Stocks that pay regular dividends (simply called dividend-paying stocks, or dividend stocks) have numerous benefits, and are typically a part of a well-balanced stock portfolio due to those benefits. But dividend stocks, while often beneficial, may come with some potential drawbacks.
Stocks that pay divdends on a regular basis are called dividend stocks and are highly sought-after as they provide a steady and reliable income stream. Especially if you rely on your stock portfolio for living expenses, such an income stream can be a godsend. Dividend stocks may generate enough cash and eliminate the need to periodically sell part of your holdings. You can then wait for a better opportunity to sell shares to pay for big-ticket items such as a car or a house.
If a firm pays regular dividends, one can assume that it isn't having a hard time paying its bills. After all, the board of directors would not approve of cash disbursements to shareholders if there is even the slightest doubt that the company may have a hard time honoring upcoming payment obligations to creditors and suppliers. Dividends, especially regular dividends, therefore send a strong message to investors that the company is financially strong.
Limited Upside Potential
When a company generates only a moderate amount of profits, it usually has to choose between distributing the cash to shareholders in the form of dividends or reinvesting the money to grow the business. Therefore, some firms that pay regular dividends may be doing so at the expense of giving up growth opportunities. This isn't always true, and highly profitable corporations may generate enough cash to both pay a dividend as well as to grow the business. Dividend-paying stocks of less profitable firms, however, may provide steady income but lack significant price appreciation.
Dividend payments are solely at the discretion of the board of directors. If the firm suddenly comes across an investment opportunity, such as a competing company being put up for sale, the board could suspend dividends and use the cash for investment purposes instead. For you, the stockholder, this would mean losing the expected income stream. If the board acts intelligently, such a bet will pay off over the long run, of course. But in the short term, you may be deprived of your expected stream of cash.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.