Common stockholders receive their returns in dividend income and capital appreciation. Dividend income puts cash in their pockets; capital appreciation means stock price increases over time. Most stock returns come from capital appreciation, but the dynamic between growth and income changes over time.
Small fast-growing companies generally do not pay dividends because they reinvest all the cash they generate back into the business to grow and expand. A stock increases in price when a company’s sales and earnings-per-share grow. The faster the earnings growth, the faster the stock can increase in price, and the higher it can go. Investors buy growth stocks for capital appreciation.
As a company gets bigger, its growth — and stock price appreciation — slows. If it no longer needs to reinvest all the profits back into the business, it may start paying a dividend. If its earnings grow, it may increase the dividend over time. Investors buy such stocks for growing dividend income and moderate capital appreciation.
Companies in mature industries such as electric and gas utilities eventually run out of growth prospects but still have strong cash flows, so they tend to pay generous dividends even while their stock prices no longer appreciate much. Investors buy such stocks primarily for dividend income and capital preservation.
Risk vs. Reward
You can make a lot more money through capital appreciation than through dividend income because a stock’s price can increase much more than its dividend, but you also risk losing more if a fast-growing stock disappoints investors and its price plunges. Dividends tend to have a moderating effect on stock price fluctuation, but buying stocks primarily for dividend income can still be risky because you can lose more from a stock’s price decline than you can collect in dividends. A company can always cut its dividend to conserve cash.
Growth and Income
Many conservative investors combine growth with income. Growth provides capital appreciation over time while dividend income adds stability to a portfolio by reducing volatility and adding to returns. Some investors do this by holding moderate growers that increase dividends over time; others may combine fast-growing stocks with generous dividend payers. Common stockholders can further enhance their returns through compounding by reinvesting dividends in additional shares of stock.
- One Up on Wall Street; Peter Lynch