Dividend Stocks – Yes or No?

If you ever find yourself in a room full of investors and you feel like having a little fun, here's something that you can try: initiate a discussion about the wisdom (or lack thereof) of choosing and buying stocks based on whether or not they pay dividends. All you really need do is start it, then just step back and watch the fireworks. This is one of the best and most sure-fire ways of creating an argument among equity investors under the sun. Some of them will not even consider a stock offering that doesn't pay dividends; others flatly refuse to buy stocks that do. Who's right and who's wrong? Let's consider each side's point of view.

We'll begin with the "Cons," the investors that wouldn't touch a dividend stock with a ten-foot portfolio. According to them, dividends are a substantially less-than-perfect way of rewarding shareholders on their investments. Their reasoning is quite simple and straightforward: the dividend earnings are not only taxed immediately, they're also taxed twice. For example, suppose a company has a strong sales year and announces that it will pay a dividend of $1 per share to its shareholders. Before it does that, however, it must pay corporate taxes on its earnings. Assuming a total thirty percent tax bracket, the $1 dividend has just been reduced to only $0.70 actually received by the shareholders. Or is it? The $0.70 will also be taxed on the individual shareholders' tax returns. If an investor is in a combined (cumulative federal and state) tax bracket of forty percent, then there goes an additional $0.28 lost to taxes. So, of the $1 announced dividend, the investor is left with less than half that amount after taxes – only $0.42, to be exact.

They further reason that, if the company makes a per-share profit of $1, it should pay its taxes and then either reinvest the $0.70 back into the business or use it to buy back outstanding shares, thereby increasing the investors' percentage share of company ownership. Either way, the value of the stockholders' shares will rise, but this increase won't be taxed at the individual level until the shares are sold. The investors would therefore receive a much larger per-share benefit ($0.70 as opposed to $0.42) and would also remain in control of when they wanted to pay personal taxes on their profits.

The "Pros" counter that a company which pays (and more specifically increases the size of) dividends is making a very strong statement about its current and future financial health; after all, it's very embarrassing for a company to ever reduce its dividend payments, thereby sending just the opposite signal. They also contend that by paying dividends, a company is effectively prevented from making poor acquisitions or funding less-profitable internal projects. These investors clearly subscribe to the old adage, "a bird in the hand is worth two in the bush."

Pro-dividend investors believe that investing only in dividend stocks is a very efficient method of screening for companies that are truly financially successful, because they actually have money to pay the dividends. They point out that more than a few organizations have been known to report earnings which were merely "paper profits," the results of nothing more than some rather fanciful methods of accounting and therefore of little actual value.

So, who's right? You've probably already guessed that they both are. It really depends upon your own financial goals, your personal investment strategy, and your own investment personality. In short, if it works for you, then it's right for you.

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