There are reasons why dividends should not matter to investors but you’ll need to understand them better to know why
Dividend investing is one of the most popular types of stock investing but do you know what determines the dividends paid by a company? How does the company decide how much to pay or even whether to pay a dividend at all?
Should dividends even be so important to investors?
This article is the 19th in our chapter-by-chapter review of The Intelligent Investor. The book was first published in the early 50s by Benjamin Graham, widely-known as the father of value investing and a mentor to Warren Buffett.
I’m reading through the 2003 edition which includes the 1973 text from Graham and the updated commentary by Jason Zweig. The book is an amazingly concise yet thorough education in investing for both defensive investors and those that want to reach for higher returns.
Check out last week’s chapter review for how to do a side-by-side comparison of stocks.
Start on the first chapter and find out how to not lose money on hot stocks.
Graham spends about half the chapter talking about dividends and the other half talking about why shareholders need to watch management of the companies in which they invest.
What are Dividends and are They Important to Investors?
Every company can make the decision to reinvest its profits for future growth or to return cash to investors in the form of a dividend. New companies with lots of growth projects usually keep all their profits while older companies will return more money to shareholders because growth projects are more limited.
When a company’s management and board of directors determines it has enough cash to invest in potential growth projects, it might decide to release any excess as a regular dividend. Most dividends are paid every three months (quarterly) though some are paid semi-annually or annually.
Setting a dividend policy is a lot more intensive than most investors realize. Management takes a hard look at expected cash flow over the next few years when determining how much to offer as a quarterly dividend. While the dividend is almost always set on a per share basis, management is more interested in the payout ratio or what percentage of net income the company will pay out as dividends.
Once the board of directors votes on a dividend, it’s set in stone. They can decrease the amount but that sends signals to investors and can cause the shares to plunge. That’s why it’s so important for management to carefully study how much the company will be able to pay in dividends.
Investors like dividends for obvious reasons. Dividends are an immediate return on your investment rather than having to wait to sell a stock for a return. Besides the return, dividends also signal to the market that management is confident in its cash flow.
How are Dividends and Buybacks Different?
Graham spends some time discussing the difference between dividends and buybacks. We’ve seen a huge increase over the last few years in the amount companies are spending to buy back their own shares so this it’s a timely subject.
Companies can decide to spend extra cash to buy back their shares. Presumably this is done because management believes the shares are undervalued and using the company’s money is a good investment. Investors benefit because the company’s earnings are spread over fewer outstanding shares so the earnings-per-share increases. If the stock trades for the same price-to-earnings after the buyback then the stock price should increase.
Low interest rates and stagnant sales growth have increased the amount companies are spending to buy their own shares.
- A company can borrow debt cheaply and buy shares (taking them off the market) to increase earnings per share
- Companies have limited opportunities to increase sales because the economy just isn’t growing very fast so it makes more sense to just use cash to buy-back the company
In theory, share buybacks should lead to an increase in the stock price. Whereas investors have no choice when it comes to accepting a dividend, they can decide when to sell a stock and take profits after a stock buyback. This makes buybacks a better decision for taxes because investors are taxed every year on dividends.
In practice, it’s not quite so simple. Investors know that determining if a stock is a good investment isn’t easy and it’s no different for management. A lot of buybacks happen after stock prices have jumped during a bull market. This means companies may be paying too much for their own stock and investors would be better off just getting the cash from a dividend.
Sometimes a stock buyback is also used to cover up overly-generous stock options paid to management. Most companies reward their executives with options to buy stock at discounted prices because it (supposedly) aligns management’s goals with the stockholders’.
The problem is that some companies offer huge stock compensation to management at the expense of shareholders. To hide the fact that the company is creating more shares every year and spreading earnings across more investors, the company buys back shares from others so the total share count stays the same.
Should Investors Care about Dividends?
Graham hits on an important argument in dividend investing. Some people say that dividends shouldn’t matter and actually destroy investor value.
The idea is that paying out a dividend forces investors to pay more taxes and to pay fees to reinvest their money…and for no real change in the investment value.
You see, issuing a dividend doesn’t really change anything for the company. If a company pays a dividend, it’s total assets go down by the amount of the dividend. That means the company is now worth less and the stock price should decrease.
In fact, a stock price will often decrease for about the same amount as the per-share dividend paid after it goes out to investors.
Graham is right though that the academic argument that dividends don’t matter misses some important practical and psychological realities.
Some of these reasons go back to the four reasons to invest in dividend stocks:
- Getting a consistent cash return is strong motivation to keep a stock and can keep investors from panic-selling during a market crash
- Dividend stocks, especially those that regularly increase the dividend, have beaten other stocks over the long-run
- The commitment to a quarterly payout may constrain management’s use of cash and lead to only the best projects being funded
Check out my dividend stocks on this page, twelve stocks and three funds that have returned 32% over the last year and beaten the S&P 500 by 7% over the period.
Can Investors Do Anything about Bad Management?
Part of chapter and most of Zweig’s commentary revolves around the need for shareholders to follow the actions of management for the companies in which they invest. The fact is that most investors never read companies’ annual reports or proxy statements.
Unfortunately, individual investors really don’t have much power when it comes to forcing change at a company. You’ll likely only have a fraction of a percent ownership in the company and individual investors only own about 40% of the stock market. The rest is owned by pension funds and financial companies, and they almost always vote along with management.
There’s an interesting parallel though with Graham’s writing and what we have seen lately. Whereas Graham starts the chapter talking about how investors were being bailed out by outside managers in takeovers, now we have seen a boom in activist shareholders. These activist billionaires like Carl Icahn can buy hundreds of millions in shares and actually have enough control to make a difference.
One important idea that you still need to follow is the amount of stock options a company is giving to management. This is one of the most common and worst issues in company’s destroying stockholder value but can be easily detected.
Companies report the amount spent on stock options on the income statement, usually as ‘share-based compensation’. You can also get an idea of the dilutive effects of the company’s program by looking at how much they spent on share buybacks and the actual change in shares outstanding.
If a company is spending a lot of money buying back its own shares but the share count isn’t decreasing much…then you may have a problem with its stock compensation program.
We’ve got just one more chapter in our review of the book. Grab your copy of The Intelligent Investor and follow along with our chapter-by-chapter review.
Dividends are an important topic for investors but there are also reasons you should prefer share buybacks. Understand how a dividend affects a company’s value and what it means to investors to decide how much you want to put to dividend investing.