Word of The Day – Dividends

Dividends – an extra slice of the pie

Definition: a periodic reward one gets for holding stock in a corporation

Discussion: Stock in a company represents ownership of a piece of the pie. Whenever a company grows or has an inflow of cash, the pie gets bigger. The company has money to spend. This money can be used for expansion, buyouts of other companies, buyback of the company’s stock, or to reward its shareholders.

Buybacks of stock can offset stock options issued as part of employee salary packages and/or boost a company’s earnings per share (EPS). Stockholders give each company a “home court advantage” in the playoffs against competing companies. When a company expands or buys out other companies, more stockholders may come to the game, i.e., buy that company’s stock. Stockholders like to see EPS rise. They also like to receive dividends. Company CEOs and boards operate their companies with an eye on stockholder approval of their actions.

During times such as the present when corporations experience growth in profits coupled with a lack of strong consumer demand for their products, corporations will boost spending on dividends. Unlike money shareholders make from buying and selling stocks and bonds that is taxed at capital gains tax rates, money shareholders make from holding onto stocks is taxed at higher ordinary income tax rates – just like the interest made on holding bonds to maturity. Capital gains are treated differently than dividends and interest by the IRS.

The bottom line is that the IRS’ differential tax treatment of buying and selling stock and bonds versus holding onto these two types of investments favors speculation in stocks and bonds.

Related terms: stock, bonds, capital gains tax