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Dividend Stocks vs. Growth Stocks

One of the common points that troubles inexperienced and aspiring investors in understanding the key differences between dividend and growth stocks and where should they invest their hard-earned money.

In this article, we will try to provide you with some crucial information about investing in dividend and growth stocks, as well as the key advantages and disadvantages these two choices come with.

What are Dividend Stocks?

While all companies want to retain their profits and reinvest them to spur further growth and launch new offerings, some of them distribute a portion of their profits to their shareholders. This distribution of profits is known as dividends and companies that pay dividends are called dividend stocks.

However, it should be noted that not all companies pay dividends as no law demands this. Companies that pay dividends are typically well-established, financially strong companies and leaders of their respective industries and sectors.

Some companies prefer to pay dividends even when they don’t make a significant profit, aiming to always award their shareholders.

There are multiple types of dividends including cash, stock, property, scrip, and liquidating dividends. Dividends are most commonly distributed through cash payments on a quarterly basis, while some companies pay them annually.

Pros of Investing in Dividend Stocks

The single most important reason why investors like to purchase dividend stocks is that they provide them with a consistent source of income or an increasing cash flow stream. Dividend-paying companies award their investors regardless of whether their share price is appreciating or declining.

Dividend stocks are particularly popular among risk-averse investors. The reason for this is that dividend companies are generally leaders of their respective industries, with strong balance sheets and well-established businesses.

As such, these companies are much better positioned to weather times of turmoil and therefore less likely to see significant stock declines, offering investors stability and peace of mind.

Because of their resilience and dominant market position, these companies are large enough to set aside a portion of their profits and pay it to their investors on a regular basis.

Cons of Investing in Dividend Stocks

The key weakness of investing in dividend stocks is the limited upside. Even though dividend stocks pay dividends to shareholders regularly, almost none of them have a dividend yield higher than 10% annually. The dividend yield refers to the amount of money a company distributes to its investors on an annual basis relative to its share price. It is typically expressed as a percentage.

Another important downside of dividend stocks is that these companies grow much slower than the so-called growth companies. This does not mean that dividend-paying companies don’t grow at all but rather that they grow at a much slower pace because they already have expanded business and therefore less room for further growth.

Above we have mentioned that companies are not obliged to pay dividends so it is important to mention that a company can also reduce its dividend payments at any time. However, this usually happens only when the company is going through a challenging period and is not able to cover its dividends with current cash flows.

What are Growth Stocks?

Growth stocks refer to companies that are expected to grow at a much faster growth rate compared to the average growth pace in their market. Put differently, these stocks have the potential to appreciate significantly quicker than their market competitors and hence provide more lucrative returns to investors.

Growth stocks are typical among risk-taking investors. They buy these stocks expecting them to quickly rise in value and lure more investors in the future.

One of the key distinctions between growth stocks and dividend stocks is that high-growth companies typically do not pay dividends. Instead, they focus on reinvesting the majority of their profits to further accelerate expansion. Also, growth stocks generally do not have sizable market capitalizations, however, some large companies are also considered growth stocks.

Pros of Investing in Growth Stocks

We can say that the number one argument for backing growth stocks is that they offer a substantially higher return upside than dividend stocks.

Another common characteristic and advantage of growth stocks is their high price-to-earnings (P/E) ratio. In simple terms, the P/E ratio is a ratio that compares a company’s current share price against its earnings per share (EPS). It is one of the common indicators used for assessing a company and understanding whether they are undervalued or overvalued.

Because of their high P/E ratio, growth companies are expected to earn strong profits in the future, making them an appealing investment choice.

Growth stocks are expected to expand rapidly because these companies usually have unique competitive advantages relative to their rivals. This, coupled with some other advantages, allows growth companies to build a loyal, rapidly-growing consumer base, which further adds to their appeal and potential upside.

Investing in growth companies is a strategy that generally bets on getting returns over a longer time frame, making it a popular choice among long-term investors who do not have or need a lot of liquidity.

Cons of Investing in Growth Stocks

Just like any other investment strategy, buying growth stocks entails certain risks. Primarily, growth stocks typically do not pay dividends which means that the only way investors can make a profit from these stocks is by selling shares at a higher price than at which they purchased them.

On the other hand, if these stocks fail to achieve their potential and meet growth expectations, investors who backed them are likely to suffer a loss.

Because of these reasons, growth stocks are considered riskier assets and that’s why one should be very cautious when investing their hard-earned money in these companies. In addition, investors who want to purchase growth stocks are advised to do a great amount of research before making the investment.

However, know that researching the market and stocks is easier said and done because one should have a sound knowledge of certain technical indicators and valuation multiples to pick the winning stock.

Conclusion

Both dividend and growth stocks come with their advantages and disadvantages. You could say that the former choice is more suitable for risk-averse investors while growth stocks could be a better pick for ‘upside chasers.’

Truth is, there is no perfect choice, and that’s exactly why many experienced investors diversify their portfolios by allocating their money to both growth and dividend stocks.

Author: Mircea Vasiu Updated: July 20, 2022