Most investors have some understanding of the benefits of dividends. It's not rocket science to realise that income stocks can provide you with a second income stream. Similarly, most understand the power of compounding and the important role dividends can play when it comes to compounding investment returns over time.
However, there are other powerful benefits of dividends that many investors fail to see. Today, I'm exploring four such 'secret' benefits.
One of the first things a dividend and its growth signals is corporate financial health.
Many investors spend a great deal of time analysing the finer details - organic revenue growth, operating margins, return on equity, etc. They stress out if a company's earnings misses analysts' estimates by 2p or operating margins fall by 1%.
Realistically, many long-term investors could save themselves a great deal of time by asking just two questions.
Did the company pay a dividend last year?
Did the company increase its dividend last year?
If the answer to both of these questions is yes, there's a decent chance the company in question is in reasonable financial shape. It indicates that enough cash flow is being generated to reward shareholders with a dividend, and that management is confident about the future prospects of the business.
Dividends also keep management in check and reduce the chances of capital being blown on poor acquisitions or mediocre projects.
For example, let's say a company generates a profit of £100m. It has two potential investment opportunities that would each cost £50m. One has a return on equity of 22% and the other 8%.
With no dividend commitments, the company may go ahead and pursue both projects, even though the return on the second project is not fantastic. However, if the company has a £50m dividend to pay, it has to be more stringent with its capital allocation. Therefore, it will most likely only pursue the best project.
A dividend payment also indicates that a company cares about its shareholders. From an investor point of view, that's important.
Consider two companies - SSE and Sports Direct.
SSE states on its website:
"We believe that our first responsibility to shareholders is to give them a return on their investment through the payment of dividends."
That statement clearly indicates that SSE cares about its shareholders. It sees dividends as a 'responsibility.'
In comparison, Sports Direct pays no dividends. What does that say about management? Most investors like dividends. To pay no dividend at all suggests little regard for shareholders.
Which company would you rather be a shareholder of?
Lastly, companies that pay out regular dividends generally attract better investors. I'm referring to investors, both private and institutional, that have a long-term focus and are rational in their approach to investing.
In contrast, when a stock has no dividend, it's generally all about fast share price gains. This attracts gambler-type shareholders, who treat the stock like a lottery ticket. This can result in volatile share price movements and large sell-offs on bad news.
Would you rather invest calmly with the first group of investors, or suffer extreme share price movements on a regular basis? I know how I'd rather invest.
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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has recommended Sports Direct International. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.