This term probably doesn’t need an explanation for most investors. But if you are just starting investing, it may not be clear but a dividend actually represents. In the context of the stock market, a Dividend represents a cash payout of earnings usually to the common shareholders of a company. Companies are not required to distribute any earnings. So, because a company has high Earnings per Share (EPS) doesn’t mean there is any Dividend at all. Most, growth companies, like Apple (APPL) and Google (GOOG) do not pay dividends. The theory is that growth companies need all available capital to fuel the companies growth.  For me the the issue of Dividends is a simple one. Who is better at allocating capital, management or myself. If management is able to put capital to use at a high return, it makes sense for the company to retain all of its earnings. If, however they a companies management cannot allocating capital as well as its investors it should distribute a dividend. This is also a reason that “mature” industries are more likely to pay dividends.

Dividends are important to an investor for several reasons.

First, Qualified Dividends are taxed at a lower rate than earned income. For a dividend to qualified a recipient  ”must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.” The maximum tax rate for qualified dividends is 15%. This compares to interest in a banking account which is taxed at your full income rate. The current tax code in effect subsidizes dividend’s over interest payments.

Second, If you own a stock that pays dividends, those pay outs will effect your overall rate of return on your investment. Obviously, dividends enhance positive returns and mitigate negative returns.

A whole school of investing follows Dividend stocks, attempting to balance dividend yield with the risk of the underlying company’s stock falling. These investors, are often called income investors, since they are looking to utilize the dividends there stocks produce as income in retirement.

I look at dividends as a way of hedging a stock price against the risk of decline. Even if the price of a stock falls, you will often still get the same Dividend. This changed last year when most Dividend companies reduced or suspended their dividends because of the financial crisis.

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