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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