Oil tycoon, investor and philanthropist John D. Rockefeller famously said, “The only thing that gives me pleasure is to see my dividend coming in.” Although some dispute the real value of paying a dividend by suggesting that companies could be better off reinvesting that cash into the business, studies show that the reported earnings of dividend-paying firms are stronger over time.
When a company pays a dividend, it dips into its cash reserves to pay existing shareholders. If you buy the stock after the dividend, the company has less cash and is worth that much less as a result. But sometimes a stock rises, even after a dividend payment. Although dividend payouts influence stock prices, they’re just one factor. Hedge funds and speculators may trade ahead of dividend payments in hopes that other investors will temporarily set a wrong price on the stock.
Changes in Earnings Distributions
In a 2004 paper, “What Do Dividends Tell Us About Earnings Quality?,” Douglas J. Skinner, an accounting professor at the University of Chicago Graduate School of Business and University of Michigan Business School, found that over the past 30 years, “there have been significant changes in the distribution of earnings … as well as in corporate payout policy, with many fewer firms paying dividends and the emergence of stock repurchases.”
Companies can generally choose between dividends and share repurchases as a way of returning excess cash to their owners. But the success of a repurchase program depends greatly on the value of the company’s stock; if the price of the stock decreases after management conducts the share repurchase, you could argue that the company didn’t get a good deal. But a dividend is cash in hand.
Skinner’s study determined that “the reported earnings of dividend-paying firms are more persistent than those of other firms and that this relation is remarkably stable over time. We also find that dividend payers are less likely to report losses and those losses that they do report tend to be transitory losses driven by special items.”
Skinner noted that results don’t hold as strongly for stock repurchases, consistent with them representing less of a commitment than dividends.
He said companies that pay a dividend have better future earnings, especially firms with larger dividend payouts, large firms and large firms with larger payouts. “The effect is related to losses but also holds when losses are excluded from the tests,” the study found.
Some investors believe that instead of paying dividends, companies should re-invest that money in an effort to grow or improve business. Others believe they’re invaluable.
Peter Vanderlee, managing director and portfolio manager of Legg Mason’s ClearBridge Advisors and a member of the Income Solutions team that co-manages the Dividend Strategy, scrutinizes dividends when picking stocks. “There is such a thing as getting in at (the) right stock price,” he says. “That’s where a lot of analysis comes in. That’s where we pick up a lot of entities on the cheap. I spend a lot of time on the dividend program.
“Why is the dividend so important? It’s certainly topical. I certainly look at the current yield based on the price of a stock. I look at management’s, or more importantly, the board of directors’ track record in maintaining or increasing dividends. Some companies we own have paid uninterrupted dividends for over a century; others have increased dividends for over 30 or 40 years in a row.”
Go Beyond Dividends in Analyzing a Company
Carefully examine a company’s historical earnings over at least five years, as well as its potential for continued growth. Dividends are just one metric for measuring a company’s profitability and overall health.
In addition to dividends, Vanderlee and his team look at how aggressive a company is at managing costs and its cash flow.
“Ultimately,” he says, “dividends are paid in cash out of free cash flow, so we analyze the free cash flow payout ratio in addition to the earnings payout ratio of the dividend. As you can see, this dividend component alone requires a lot of analysis and a lot of digging.”
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