Last Updated on 11 January 2021 by Dan
Hello everyone! Today we’re going to be looking at a question about investment styles, in the form of if it’s a better option to invest into growth stocks or dividend stocks (sometimes also known as yield or income stocks).
Where this comes from is the fact I’ve seen a number of blogs quite heavily document their monthly gains from dividends as part of a diary, and novice investors may be wondering what the difference is, and what this might mean for them.
As ever all the below is not financial advice tailored for your situation and all investment decisions are yours alone – see our disclaimers page for full details.
And don’t forget that if you’re new to investing, with have some other great posts in our Starting to Invest series.
So what is a dividend?
Let’s start with the basics. Fundamentally our reason for investing by giving a company some money is that we expect some form of return on that.
Ideally, you hope a company is using it’s financial resources to generate revenue and profit. There then becomes a question of what the company does with this money, and that’s where the two approaches to investing begin to diverge.
In the case of the dividend, the company makes a promise to make a payment to all shareholders at a particular date, effectively distributing their cash. This amount is set by the company and declared in advance.
The relationship between price and the amount of cash the company is distributing is known as the dividend yield.
To demonstrate this with an example – if Theoretical Co. is trading at £100 a share, and declares a dividend of £2 a share per year to be distributed, it’s yield is 2%.
In practice, dividends are usually paid on a quarterly schedule, however any yield percentage you find on financial websites will be based on an annual basis – i.e what the yield would be if you’re held the stock for a year.
Why do companies pay dividends?
There’s a few reasons for this:
- To make the company more attractive to investors, who can build the dividends in to their expectations of return.
- It can demonstrate faith in the companies future profitability (that the company can afford to do this.)
- The company may be at a stage of maturity where it no longer needs to invest in major capital projects – thus to distribute returns to shareholders becomes a more efficient use of driving company value than sitting on a large pool of cash.
It’s simply a company that has chosen to have a different dividend policy. Instead of distributing cash to shareholders, this company would retain their profits and instead of paying it out, would put it back into the business and put into investment projects.
The theory is that these projects will boost the capacity and value of the company more than paying a dividend would be.
What is the better policy – pay a dividend or focus on growth?
There’s no right or superior answer between the two approaches – it’s largely a matter of company need. You might potentially expect smaller companies to be more inclined to focus on growth a business tends to be expensive in terms of capital. A more established business may not need the money and be more inclined to pay a dividend.
When looking at a stock for investment purposes, the most important thing is that whatever the companies policy is that it makes logical sense in supporting their business strategy.
What are the advantages or disadvantages of investing for dividends and income?
The advantages of dividend investing:
- When a company pays a dividend you’ll receive it then and there. You can therefore have the flexibility to use it for immediate passive income or reinvest it as works for you.
- Equally because you’ve been paid it’s out you physically have that money, rather than theoretical gain in a stock price.
- As the company declares a dividend in advance, you know the broad yield and can work this into your expectations.
- If a company is in a position to pay a dividend, it’s likely in a position where it has a constant stream of steady earnings.
The disadvantages of dividend investing:
- The company ultimately controls the rate at which they pay out the dividend, which can expose you to the risk of shock if the company suddenly cuts their dividend. (As share price is also influenced by the yield, expect the share price to drop when this happens to).
- Once a company starts to pay a dividend it can become something of a market expectation they continue to do so – so they may not stop for risk of damaging the share price, even when it might be more sensible from a business perspective.
- The money being distributed to shareholders limits the amount of money being reinvested into the company, and could close off growth opportunities.
What are the advantages or disadvantages or investing for growth?
The advantages of growth investing:
- The company has immediately flexibility in situations where a downturn in the economy may mean that it’s safer to retain cash flow.
- Company share prices may be less affected by changes in dividend policy, and more of the raw fundamentals of the business model.
- Not having to worry about a dividend gives the biggest incentive to the company to push it’s retained earnings into prospects to growth the company, hopefully increasing it’s value.
This disadvantages of growth investing:
- All of your return is tied up in the share price.
- Just because a company has the flexibility of more cash flow, doesn’t mean it’ll necessarily use it well.
- You’re more tied in to the longer term prospects of business models, which have a lot of variables to make them hard to predict and in some cases more volatile.
So Dividends or Growth – which is better?
Neither is a superior approach, but different options might be better for you based on your investment profile.
If you want the flexibility of being able to have a consistent income stream, focusing on dividends may be better for you. If you’re willing to set there for the long term and believe in the business model, a long term buy and hold as you support a company that’s expanding can be very lucrative and rather personally rewarding where you support a good story.
My suggestion is unless you’re very specifically building your portfolio around specific aims, finding companies with a effective business model and demonstrating value vs. the price of a stock is much more important that aggressively targeting dividends or growth, and focus more on the merits of the company and if their payout policy makes sense.
Investing in a company with a 15% yield won’t benefit you if the cash flow to service those dividends is bleeding the company dry. Equally, growth requires a good product that has something that makes it superior to competitors – just because a company has the ability to grow, doesn’t mean people want what they’re selling.
We’d like to hear from you
We’d love to hear from you in the comments if you favour a particular style between income and growth and have had good or bad experiences with either, or think we’ve missed something in the advantages or disadvantages.