Using Dividends for Income: Comparing Stocks
By Gary Silverman, CFP®
Last week we finished a brief look at how one might go about living off the income from a portfolio without touching the principal. Part of this examined the use of dividend-paying stocks. Today I want to continue in that vein and answer the question: Are dividend-paying stocks safer than those that don’t pay out?
It seems obvious that if a stock regularly pays a dividend it must be safer. After all, no matter what happens to the price of the stock at least you get some income from it. But before we accept this at face value let’s look at how this might work. I’m piggy-backing on some work done by Bob French. You can find a lot of articles on investing for retirement by him and another excellent researcher, Wade Pfau, at RetirementResearcher.com.
The example that French uses goes something like this: Imagine company X and company Y. Both companies sell for $100 per share. They have a great year in 2018 and both have profits equal to $20 per share. All things being equal (they never are) the price of their stock should rise accordingly to $120 per share (the $100 it started at plus the $20 profit added to the company’s balance sheet). Now, company X uses the money to invest in itself or to fill a pit that employees can jump in…in any case it keeps the money. But company Y pays out the $20 per share profit in the form of a dividend to shareholders. All things being equal the price of Y should go back to $100 per share ($100 plus $20 profit minus $20 dividend).
Those who own company X own a stock worth $120. Those who own company Y own a stock worth $100 and have $20 in their pocket. Note the lack of a difference in value between the two. (Hint: there is none.)
Now, some would argue that company Y is safer, because your $20 is in hand and no longer at risk should the company go bankrupt. True. But if you owned company X and had the same concern, you could always sell one-sixth of the stock (the equivalent to them paying you $20 a share). Still others contend that company Y is more likely to go bankrupt because it has less money in reserve.
This is why I am not too concerned with whether a company pays a dividend or not. You can see that the value is the same regardless. But the question we began with was whether dividend-paying stocks are safer than those that don’t pay them. And the answer is “generally yes.” This has nothing to do with the fact that they paid out a dividend. Rather it is because companies that pay out dividends only start doing so if they are very sure they can afford it. This means that they are on very sound financial footing plus some.
However (yes, that word again), it also means that they tend to not grow as fast since they have less money to invest in that growth. Sorry, maximizing growth and income in the same investment doesn’t happen. Like the turtle taught us, slow and steady win the race.
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing