Author: Ananth Rao
The BRB Bottomline
Dividends are payments by companies to investors. Although dividends are frequently cited as a positive factor to consider in evaluating companies, this is often irrational. After all, a well-managed company should be able to use the dollar they give to an investor better than he can on his own, and every dollar gained in a dividend is a dollar lost by the company.
On reading this title, you may be confused. After all, aren’t dividends the holy grail of income investing? Don’t investors protest every time they are decreased? Isn’t a healthy dividend one of the first things to look for when evaluating a company? While the first two statements are true, I think that the last one needs further evaluation.
A dividend is a sum of money paid out by companies to investors on a regular basis (usually quarterly). They are typically a portion of the company’s quarterly earnings, although in tough times companies may dig into their reserves or (if they are especially reckless) go into debt to pay out dividends. The reason that companies are so desperate to ensure the regular payment of dividends to investors is because the jobs of the top executives depend on it. If dividends are decreased or especially if they are taken away altogether, executives’ approval ratings will plummet and, if investors are especially displeased with the adjustments, leadership changes may ensue. This attitude of investors of no-tolerance towards dividend decreases is often short-sighted and somewhat irrational.
While it may make sense for investors to blame the leadership for the events that led to dividend decreases (e.g., poor management, product delays, decreased profits, and decreased dividends), just being upset at lowered dividends is illogical for the investor. This is because dividends themselves do not actually help investors: every dollar gained by an investor is a dollar lost by the company, which means that investors lose at least one dollar in share value for every dollar per share in dividends they receive. In fact, in a well-managed and growing company, the dollar gained by the investor in the dividend is decreasing the value of his share by more than a dollar, because well-managed companies will be able to reinvest in themselves—whether in their employees, facilities, or factories—more effectively than you can reinvest in companies as an outsider. If a company is offering a large dividend (in comparison to its earnings) you can typically assume that at least one of the following is true about the company:
1. The company is unlikely to grow and may be in a declining industry and thus is unable to effectively spend its earned capital.
2. Investors do not completely trust management and thus want their money immediately rather than letting the management handle it.
3. Executives are short-sighted and more interested in placating short-sighted income investors than in ensuring the long-term success of their companies, as in the case of General Electric (GE). This may be the most common of the three and is especially common when the top executives are not founders. This is because in such cases the executives’ net worth is more closely aligned with their salary and the length of time they can keep their jobs than with the delivery of long-term value, as they typically do not own a high percentage of the shares of their companies.
Moreover, if the dividend yield is higher than the company’s earnings in a particular quarter, this means that (unless the company has massive cash reserves and very low debt) management is highly irresponsible because the company is unsustainably losing money in the quarter and management is likely corrupt for reason (3). Also, companies with a high ratio of dividend payout to earnings may have lower cash reserves, since they will have paid out most of their earnings to investors, although cash reserves are separate statistics that you should check on their own. If you are a long-term investor, you want high-growth, well-managed companies that will fare well for generations to come, even if their share prices come at a premium, so you likely don’t want to invest in companies that have any of the above three properties. Hence, if you are considering investing in a high-dividend company, scrutinize its growth rates, CEO ratings, cash reserves, debt, and overall sector growth rate.
Some people, particularly those nearing retirement age, may argue that they like dividends because of their seemingly safe, consistent payout. However, if you are looking for such safe investments (which undoubtedly must constitute part of your portfolio regardless of your age), you aren’t going to find them in the stock market, which regularly shifts in price with every boom and bust. Instead, annuities and municipal and foreign bonds pay a much safer, steadier stream of money that you can rely upon except in the absolute worst of financial disasters.
While high dividend yields may be alluring on their surface, they can often mask companies’ financial or managerial problems. When investing in a high-dividend company, carefully scrutinize the company’s financials and management ratings to ensure that the dividends, along with the company, can survive for decades to come.
Ananth is a sophomore at U.C. Berkeley pursuing dual degrees in E.E.C.S. and Economics. He is passionate about investing and financial education, and blogs about it on StockTalk.us. When he’s not working on an article or researching investments, he likes playing chess and basketball with friends, watching WWII documentaries, and hunting for the best burrito in Berkeley.