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Why Dividends Really Make a Difference

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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:

Learn about which dividend stocks will keep their high-paying ways with help from our Motley Fool Income Investor newsletter. PepsiCo is just one of its stock recommendations. A 30-day free trial gives you no-holds-barred access to all our recommendations, analysis, and much more -- click here to start today.

Fool contributor Dan Caplinger loves getting those dividend checks month after month. He owns shares of Freeport-McMoRan. Activision Blizzard is a Motley Fool Stock Advisor pick. Pfizer and Wal-Mart are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always matters to us.

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  • Report this Comment On May 19, 2009, at 11:05 AM, madmilker wrote:

    American Made makes a bigger difference...

    People in America need to realize jus what got America in this shape…”cheap” yes so-call cheap items from a foreign land.

    quote*Wal-Mart firmly believes in local procurement. We recognize that by purchasing quality products, we can generate more job opportunities, support local manufacturing and boost economic development. Over 95% of the merchandise in our stores in China is sourced locally. We have established partnerships with nearly 20,000 suppliers in China. *end quote!

    Now! if there be 182 country’s making items for the world to buy and they have only 5% of the pie in China…duh! This company makes the nice people of China support their currency(yuan) by keeping it in their country working for the people there…. but with the “yuan” going up in value and the US dollar going down…all the foreign items that the American consumer buys thinking it is cheap has went up in price.

    People…its all about the currency and to keep a currency strong you got to keep it floating around the country you live in so it can work for you. For the past 12 years all them US dollars are being shipped overseas to a foreign bank and with the American worker not making anything for the foreigner to buy the “we the people” have to turn to the “second” largest employer in America(Uncle Sam) to sell “we the people” debt in order to get all them dollars back!

    50 years ago a foreigner would had given their left nut for a US dollar or a Hershey’s chocolate bar and today the same foreigner has got Uncle Sam and the American consumer by both all the while Hershey is moving the chocolate factory to Mexico. Wake up! America and think “MADE IN AMERICA.”

    quote*"Considering that there are over 30,000 ships at sea this morning," writes James Carlton, director of the Williams College-Mystic Seaport Maritime Studies Program, in an e-mail, "the total number of organisms and species in this global 'bioflow' on the morning your readers read your piece could be staggering - billions of individuals, and thousands of species."

    Indeed, scientists have long considered ballast water the primary way invasive aquatic organisms are introduced. From the zebra mussel's arrival in the Great Lakes, to an American jellyfish severely disrupting Black Sea fisheries, the potential costs of accidental introduction of a species to new homes can be tremendous. Aquatic invasives cost the US $9 billion yearly, according to estimates by David Pimentel, professor emeritus of ecology and evolutionary biology at Cornell University in Ithaca, N.Y. Zebra and quagga mussels (a cousin to the zebra) alone cost the $1 billion annually.*end quote!

    tat is $9 billion a year in hidden taxes to all Americans...

    cheap ain't chic and it cost!

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