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Dividend Growth Reveals the Path to Profits

NEW YORK (TheStreet) -- The fact that investors love dividends so much has always fascinated me. After all, they create a double tax hit that sends more money to the government and wastes capital.

Here's how: The dividend-paying company pays taxes on its earnings before giving the dividend to shareholders, who in turn pay taxes on the dividends. If the company had simply held the cash, capital would have been preserved (assuming that the company doesn't waste it) and less would have flowed to the government in the form of taxes paid by shareholders.

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Still, shareholders like to have cash returned to them. It's a bit like the old saying "a bird in the hand is worth two in the bush." The fact that the tax on qualified dividends was reduced to 15% back in 2003 has certainly been a sweetener. So has the extremely low interest rate environment we are currently dealing with, where cash yields next to nothing and 10-year Treasuries will get you about 1.9%. The S&P 500 yields 1.96%, and there are hundreds of companies with higher yields.

While yield may be important to many investors, dividends provide other benefits that many investors overlook. For example, they can be a great indicator of a company's health, especially when they raise their payouts.

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Unlike other financial measures, dividends don't lie. They are paid in cash (which some investors may choose to reinvest back into shares), and can't be manipulated. A company can't declare a 10 cent dividend, but only pay 5 cents.

Compare that to the one measure of success the market focuses on quarter after quarter: earnings. There's so much variability in how companies report earnings, and what's included in the calculation can make your head spin. While it's legal, you have to question a company that reports yet another earnings number that excludes "one-time charges."

With dividends, you know what you're getting. When I see a company raising its dividend year after year, I view that as a sign that management is confident in the company's future. To raise a company's dividend when its prospects are dim would be imprudent at best. After all, no one likes to reduce or eliminate a dividend. That suggests a company may be in trouble, causing investors to head for the sidelines and send the stock price lower.The damage here is typically most severe when the dividend cut is a surprise.
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