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Many financial minds tout dividend-paying stocks as the solution to turbulent markets. Yet why do investors make such a fuss over what amounts to getting a small reward for their investment?
Long seen as a way to stabilize your portfolio through stormy conditions, dividend stocks have gotten a lot of attention lately -- for both their successes and their failures. While stalwarts like PepsiCo (NYSE: PEP ) and Wal-Mart (NYSE: WMT ) continue long streaks of increasing their payouts year in and year out, plenty of others, including Freeport-McMoRan (NYSE: FCX ) and Pfizer (NYSE: PFE ) , have cut or eliminated dividends entirely. Now, opinion seems divided on whether investing in dividend stocks is a smart move that will protect your portfolio, or a risky one that could cost you if more companies reduce or get rid of payouts.
It's just a check
But on one level, it doesn't seem like a dividend should matter that much. Look at it from the company's perspective. Before the company pays a dividend, it has a certain amount of cash on hand. It could use that cash for any number of purposes, from making acquisitions to reinvesting in business operations to repaying debt.
After it pays the dividend, the company has that much less cash. Theoretically, then, its intrinsic value drops by exactly the amount of money that it just paid to shareholders. That's why you'll often see individual stocks fall after their dividend payment becomes effective -- their ex-dividend date -- because shares that don't include that dividend payment are simply worth that much less.
In some ways, a dividend-paying stock has a lot in common with companies that declare stock splits. When companies like Myriad Genetics (Nasdaq: MYGN ) and Activision Blizzard (Nasdaq: ATVI ) split their shares 2-for-1, they've simply doubled the number of shares outstanding, while cutting their value per share in half. Similarly, a cash dividend just moves some money from the company's bank account to yours -- it doesn't somehow increase the value of the stock.
A sign of things to come
However, dividend payments do signal that a company believes its business is sustainable over the long term. If a company is able to pay money back to shareholders in the form of a dividend, it must be generating enough free cash flow to finance the payouts. And if the company regularly pays dividends, those cash flows must be ongoing and dependable.
Yet as many have discovered, a past history of dividend payments doesn't necessary ensure the security of future business prospects. Many companies, including Dominion Resources (NYSE: D ) , finance their dividends not from free cash flow, but rather by raising capital, either through taking on debt, selling assets, or by selling additional shares into the secondary market. Clearly, if a company substantially increases its debt load just to pay dividends, you might consider its stock more risky than it would be if it didn't make a payout.
Don't dismiss dividends
All this means that you shouldn't just assume that any stock that pays a dividend is destined for greatness. But on the other hand, you shouldn't discount dividends entirely, either. Given that dividend-paying stocks have historically outperformed stocks that don't make payouts by a substantial margin, it's clear that for every questionable dividend stock, there are many others that have the goods.
So if recent events have you feeling uncomfortable about investing, give dividend-paying stocks a second look. As long as you do your due diligence and use your research to weed out potentially dangerous stocks, the benefits from receiving regular dividends will add up to a substantial portion of your wealth over the long haul.
For more on how to make the most of dividends, read about: