Two Key Things To Understand About Dividends

Dividends represent the gains from profits investors earn from having shares in specific businesses or companies. Here are two important things to consider.

Dividends represent the gains from profits investors earn from having shares in specific businesses or companies. Naturally, dividends are one of the key perks of investing in shares.

While companies have their different patterns when it comes to paying out dividends from the number of times they pay it, the percentage pay-out as well as what they pay out (like cash, stocks, or properties as discussed in our last article), there are certain key elements that the investor should understand. They include:

1: Dividends Are Based On Cash Flow

One of the confusing things about a financial statement for non-financial individuals, is the difference with accounting disclosures and what actually exists physically. Non-cash items like depreciation, amortization and sometimes even capital gains do not actually involve the movement of cash.

In similar fashion, there are situations where a company looks like it has a lot of money in its books but it cannot actually pay dividends because the actual cash flow is low. This is an important point in understanding how dividends work:

They are not dependent on reported earnings; rather, they are dependent on the cash flow of the company. This can essentially work both ways: The first way is the first example we gave: it could report profit but not have enough to pay dividends but the second is that it could also declare and pay dividends without having made a profit that year (based on Generally Accepted Accounting Principles (GAAP).)

A core reason a company could pay dividends even when it didn’t make profits and as long as it has the cash flow to do so, is because most dividend companies are deemed to be realiable and stable. For the purpose of proving their stability regardless of what is going on, it could pay dividends still so that investors will not panic and sell their stocks.

Again, for the purpose of this stability, even when a company makes more money than expected in a given year, it will also not raise its dividend pay-out to be significantly high. They will rather focus on a sustainable outcome. This is why it will also not lower the dividends even when it is facing temporary setbacks.

2: Dividend Reinvestment

One of the key tenets of being able to exponentially increase your money is reinvestment. By reinvesting your dividends, you obtain more stake in the business and even get to spread your purchase across different prices.

When reinvesting your dividend using a dividend reinvestment plan especially when investing in foreign stocks, dividend payments will no longer be automatically credited to your brokerage account and will instead used to purchase more shares. Where this service exist, you get to enjoy an automated system of consistently investing your cash earnings.

Even when it is not automated, the advantages of reinvesting cannot be overemphasized. Dividend reinvestment plans also give the investor the opportunity to purchase fractional shares. The more you reinvest, the more stake you garner in the company.

In a stable company, these dividends will earn you more dividends, which will in turn earn you more dividends. That’s a key trick to growing wealth with dividends.

Written by Lawretta Egba