Author Dave Van Knapp
EXCERPT FROM CHAPTER C-9: DIVIDENDS AS A COMPANY
EVALUATION FACTOR
What Are Dividends?
Dividends are portions of a company’s earnings paid out (usually quarterly)
to the company’s shareholders. They are transfers of cash by the corporation
to its owners.
As we saw in the black box discussion, after all expenses and taxes have
been paid, what’s left is the company’s earnings. A company has decisions to
make as to what to do with those earnings:
• It may choose to plow back all of its earnings into the company to
fund growth, acquisitions, special projects, and company improvements.
• It may siphon off some of those earnings and send them in the form
of dividends to shareholders.
• It may use some of its earnings to buy back shares of itself on the
open market.
Thus, dividends are discretionary with each company. No company has to
pay dividends. Dividend programs (or the lack thereof) reflect the company’
s philosophy and strategy regarding the proper balance between sharing
profits with shareholders now versus using that money for reinvestment in
the company, leading (presumably) to enhanced value in the future.
Once begun, dividend programs tend to persist. A company that pays a
dividend does all it can to keep doing it. Investors count on dividend-paying
companies to keep paying them. Most management teams are loath to cut
dividends, because of the negative signal it sends to the investment
community. Stable and increasing dividends usually indicate that the
company’s management has confidence in the company’s prospects....
As a general rule, dividend-paying companies tend to be larger and older
than their non-dividend-paying brethren. Many of them have been paying
dividends uninterruptedly for decades. Often, the dividend payout is raised
annually.
Investor sentiment tends to wax and wane with regard to dividends and the
companies that pay them.... [B]y the time of the bull market of 1982–1999,
there was far less interest in dividends than in share price growth. The
humongous rise in share prices during the long bull market dwarfed
dividends’ contribution to total return....
But when the bubble started to deflate in 2000, with stock prices going
backward, investors’ interest was rekindled in dividend-paying stocks. So
while it is true that during the inflation of the bubble dividend-payers did
not go up as much, it is also true that during the deflation they did not lose
as much. A study by Smith Barney showed that non-dividend-paying stocks
fell an average of 60 percent in the first 15 months following the market’s
peak in early 2000, while dividend-paying stocks fell an average of 20
percent. That follows a general historical pattern of dividend-paying stocks
providing a “cushion” in a down market while also participating (but not as
greatly) in market upswings.
Most studies show that 45 to 50 percent of the total return of the stock
market during the twentieth century was made up of dividends, despite the
significant decline in contribution during the final twenty years....
In 2003 the federal tax laws were changed to cap the income tax on
dividends at 15 percent, making them the least-taxed component of total
return, and this has helped spur recent increases in both the number of
companies paying dividends and the payout rates....
Pros and Cons of Using Dividends to Evaluate Companies
Some companies pay dividends; others do not. Some of the greatest
companies of our time (such as Warren Buffett’s Berkshire Hathaway) have
never paid a dividend. During its heyday, Microsoft, one of the all-time
great wealth producers, never returned any of its earnings to shareholders. It
kept all of it. (Microsoft eventually built a cash hoard in the tens of billions
of dollars and finally began a dividend program in 2003.)...
Reasonable minds differ on whether a company’s dividend policies tell you
anything useful about how good the company is. Let’s look at the pros and
cons and make up our own minds.
Here are the principal reasons for believing that a company’s payment of
dividends is a good sign about the company:
• A company that pays dividends—especially rising dividends—must
be financially solid; otherwise the Board of Directors would not pay out the
money. The dividend’s payment suggests that cash flow is above and beyond
what is needed to reinvest in the business to grow and improve it. A
dividend payout probably indicates management’s confidence in the stability
and growth of future earnings, quite possibly based on information that is
not publicly available.
• Dividends are “proof” of profits. A company paying dividends has no
issues with quality of earnings: It must have cash to make the payments....
• Such a company, because of its strong financial position, does not
need to return to the capital markets often, if at all, to fund its growth. It is
self-funding, with cash left over.
• A company that pays dividends will probably invest the earnings it
does retain more carefully. The dividend program imposes discipline upon
management. Companies with less retained earnings make better decisions
about what to do with the remaining money....
• Conversely, a company that retains all of its earnings may waste or do
stupid things with the money. For example, a company with “too much cash
around” may make ego-driven acquisitions, overpaying for them and then
compounding the error by failing to integrate them properly. Or the
company may fund development projects of dubious value (again, these are
often ego-driven), make high levels of capital expenditures, become lax
about controlling costs, spend more and more on perks for executives,
“trophy” headquarters buildings, and the like....
• Several studies suggest that companies that pay dividends tend to
perform better over the long haul. For example, a 2003 study by Standard &
Poor’s found that a basket of U.S. stocks with the best history of boosting
dividends and profits had an annual compounded return of 12.3 percent (vs.
10.8 percent for the S&P 500) over the prior 17 years.....Similarly, Jeremy
Siegel reports in The Future for Investors (2005) that the 100 highest-yielding
stocks in the S&P 500 have performed better (in total return) than the index
as a whole over the past 50 years.
In contrast, these are the reasons most often given that companies which are
better investment opportunities do not pay dividends:
• Companies that are on a growth track need all the money they can to
make acquisitions and fund good internal projects. Therefore, it is in the
long-term interest of shareholders that the company not pay dividends but
rather that it reinvest in the company’s growth and improvement....
• The payment of dividends suggests that the company does not have
enough good reinvestment ideas—i.e., it is a maturing, mature, or stagnating
business.
• If the company wishes to distribute earnings to benefit shareholders
immediately, share buyback programs are a more tax-efficient way of
accomplishing that end....
[What Do We Think?]
The Sensible Stock Investor finds the first set of arguments to be the more
compelling. That is, the payment of dividends, especially a long history of
paying increasing dividends, probably points to superior companies with a
higher probability of sustained earnings growth. In particular, a company
with a strong dividend record suggests that it can hold up the “sustained”
part of the bargain in terms of earnings growth....[T]here is little doubt that
a past history of paying and increasing dividends is usually a sign that
management has confidence in the company’s continued earnings power.
EVALUATION FACTOR
What Are Dividends?
Dividends are portions of a company’s earnings paid out (usually quarterly)
to the company’s shareholders. They are transfers of cash by the corporation
to its owners.
As we saw in the black box discussion, after all expenses and taxes have
been paid, what’s left is the company’s earnings. A company has decisions to
make as to what to do with those earnings:
• It may choose to plow back all of its earnings into the company to
fund growth, acquisitions, special projects, and company improvements.
• It may siphon off some of those earnings and send them in the form
of dividends to shareholders.
• It may use some of its earnings to buy back shares of itself on the
open market.
Thus, dividends are discretionary with each company. No company has to
pay dividends. Dividend programs (or the lack thereof) reflect the company’
s philosophy and strategy regarding the proper balance between sharing
profits with shareholders now versus using that money for reinvestment in
the company, leading (presumably) to enhanced value in the future.
Once begun, dividend programs tend to persist. A company that pays a
dividend does all it can to keep doing it. Investors count on dividend-paying
companies to keep paying them. Most management teams are loath to cut
dividends, because of the negative signal it sends to the investment
community. Stable and increasing dividends usually indicate that the
company’s management has confidence in the company’s prospects....
As a general rule, dividend-paying companies tend to be larger and older
than their non-dividend-paying brethren. Many of them have been paying
dividends uninterruptedly for decades. Often, the dividend payout is raised
annually.
Investor sentiment tends to wax and wane with regard to dividends and the
companies that pay them.... [B]y the time of the bull market of 1982–1999,
there was far less interest in dividends than in share price growth. The
humongous rise in share prices during the long bull market dwarfed
dividends’ contribution to total return....
But when the bubble started to deflate in 2000, with stock prices going
backward, investors’ interest was rekindled in dividend-paying stocks. So
while it is true that during the inflation of the bubble dividend-payers did
not go up as much, it is also true that during the deflation they did not lose
as much. A study by Smith Barney showed that non-dividend-paying stocks
fell an average of 60 percent in the first 15 months following the market’s
peak in early 2000, while dividend-paying stocks fell an average of 20
percent. That follows a general historical pattern of dividend-paying stocks
providing a “cushion” in a down market while also participating (but not as
greatly) in market upswings.
Most studies show that 45 to 50 percent of the total return of the stock
market during the twentieth century was made up of dividends, despite the
significant decline in contribution during the final twenty years....
In 2003 the federal tax laws were changed to cap the income tax on
dividends at 15 percent, making them the least-taxed component of total
return, and this has helped spur recent increases in both the number of
companies paying dividends and the payout rates....
Pros and Cons of Using Dividends to Evaluate Companies
Some companies pay dividends; others do not. Some of the greatest
companies of our time (such as Warren Buffett’s Berkshire Hathaway) have
never paid a dividend. During its heyday, Microsoft, one of the all-time
great wealth producers, never returned any of its earnings to shareholders. It
kept all of it. (Microsoft eventually built a cash hoard in the tens of billions
of dollars and finally began a dividend program in 2003.)...
Reasonable minds differ on whether a company’s dividend policies tell you
anything useful about how good the company is. Let’s look at the pros and
cons and make up our own minds.
Here are the principal reasons for believing that a company’s payment of
dividends is a good sign about the company:
• A company that pays dividends—especially rising dividends—must
be financially solid; otherwise the Board of Directors would not pay out the
money. The dividend’s payment suggests that cash flow is above and beyond
what is needed to reinvest in the business to grow and improve it. A
dividend payout probably indicates management’s confidence in the stability
and growth of future earnings, quite possibly based on information that is
not publicly available.
• Dividends are “proof” of profits. A company paying dividends has no
issues with quality of earnings: It must have cash to make the payments....
• Such a company, because of its strong financial position, does not
need to return to the capital markets often, if at all, to fund its growth. It is
self-funding, with cash left over.
• A company that pays dividends will probably invest the earnings it
does retain more carefully. The dividend program imposes discipline upon
management. Companies with less retained earnings make better decisions
about what to do with the remaining money....
• Conversely, a company that retains all of its earnings may waste or do
stupid things with the money. For example, a company with “too much cash
around” may make ego-driven acquisitions, overpaying for them and then
compounding the error by failing to integrate them properly. Or the
company may fund development projects of dubious value (again, these are
often ego-driven), make high levels of capital expenditures, become lax
about controlling costs, spend more and more on perks for executives,
“trophy” headquarters buildings, and the like....
• Several studies suggest that companies that pay dividends tend to
perform better over the long haul. For example, a 2003 study by Standard &
Poor’s found that a basket of U.S. stocks with the best history of boosting
dividends and profits had an annual compounded return of 12.3 percent (vs.
10.8 percent for the S&P 500) over the prior 17 years.....Similarly, Jeremy
Siegel reports in The Future for Investors (2005) that the 100 highest-yielding
stocks in the S&P 500 have performed better (in total return) than the index
as a whole over the past 50 years.
In contrast, these are the reasons most often given that companies which are
better investment opportunities do not pay dividends:
• Companies that are on a growth track need all the money they can to
make acquisitions and fund good internal projects. Therefore, it is in the
long-term interest of shareholders that the company not pay dividends but
rather that it reinvest in the company’s growth and improvement....
• The payment of dividends suggests that the company does not have
enough good reinvestment ideas—i.e., it is a maturing, mature, or stagnating
business.
• If the company wishes to distribute earnings to benefit shareholders
immediately, share buyback programs are a more tax-efficient way of
accomplishing that end....
[What Do We Think?]
The Sensible Stock Investor finds the first set of arguments to be the more
compelling. That is, the payment of dividends, especially a long history of
paying increasing dividends, probably points to superior companies with a
higher probability of sustained earnings growth. In particular, a company
with a strong dividend record suggests that it can hold up the “sustained”
part of the bargain in terms of earnings growth....[T]here is little doubt that
a past history of paying and increasing dividends is usually a sign that
management has confidence in the company’s continued earnings power.
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