Dividend shares can be the best of both worlds.
We often get this question in various forms here on the Fool site:
Why would you want to own dividend paying stocks? If the company pays a dividend it means it lacks growth potential.
It's easy to see why some investors draw this conclusion. After all, a company that's paying you cash isn't reinvesting that cash in the business.
That's true, but as investors, we want to own companies that are maximising shareholder value, and that isn't necessarily the same thing as maximising growth.
Here's what I mean
First, let's determine why a company pays a dividend in the first place.
Companies create shareholder value by investing in projects that earn excess returns over their cost of equity. For example, Company XYZ creates value by investing in projects returning 25% when it only cost 8% to raise the funds. On the other hand, if it's only making 3%, then it's destroying value.
Eventually, as companies get larger and (hopefully) more profitable, value creating investments still exist, though there often aren't enough to go around. Sticking with Company XYZ and its 8% cost of equity, let's say it had £1 million to invest in the following projects, which should it choose?
| | Potential Return | Maximum Investment |
|---|
| Project A | 15% | £500,000 |
| Project B | 10% | £200,000 |
| Project C | 5% | £300,000 |
Projects A and B would create shareholder value, but Project C wouldn't because the return is below the cost of equity. That leaves the extra £300,000 unused.
At this point, the company has some choices. It can:
- save it;
- buy back shares; or
- pay it out as dividends.
Most firms do some combination of all three, but their ultimate focus should remain on maximising value. For instance, if a firm needs to improve its financial health or if it sees more profitable projects a year from now, then saving the cash is a reasonable action.
Conversely, if the company's balance sheet is already strong and doesn't anticipate more profitable projects, then the excess earnings should be returned to shareholders either through share buyback, a cash dividend, or a combination of both.
Share buyback versus dividends
In a perfect world, where things like taxation and transaction costs matter not, a company's choice to buy back shares or pay cash dividends would have the exact same effect on shareholder wealth.
But, alas, this isn't a perfect world and the imperfections make dividend policies different across markets.
Where I am in the US, for example, the average dividend yield is lower than in the UK at least in part because of differences in taxation of dividends and capital gains. Before a change was made in 2003, dividends were taxed at US investors' ordinary income rate, which ranges between 10% and 35%, while long-term capital gains (on investments held over one year) were taxed at a lower rate.
Today, so-called "qualified" dividends are capped at either 0% or 15%, depending on your income level, thus putting the rates on par with capital gains, but that tax break is set to expire this year.
This traditional arrangement of taxing capital gains at a lower rate than dividends fuels US investor preference for share buybacks. In 2007, according to Standard & Poors, companies spent 180% more on buybacks than dividends.
Yet, herein lies the problem with many share buyback decisions -- companies too often buyback shares when they're overvalued and refrain when they're undervalued, thus lessening the capital gain tax benefits. In 2009, for instance, when share prices were much lower than in 2007, US share buybacks fell by 86%. I imagine the situation is much the same in the UK.
This frequent misuse of investor capital is why famed value investor, Benjamin Graham, argued in Security Analysis, "a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus [by the company]."
In other words, a dividend, unlike a capital gain, is more certain and it's the investor -- not the company -- who has the control. For if the company is undervalued, the investor can buy more shares, reinvest it somewhere else, or use the cash to buy groceries. The choice is up to them.
Coming full circle
So far, we've answered how dividends can help maximize shareholder value, but they can also be a signal to the market that future profitability is strong and that management is intent on sharing that profitability with shareholders. Such signals, contrary to the "dividends equal slow growth" argument, can actually accelerate share price growth, as well.
In fact, as a 2003 study by Robert Arnott and Clifford Asness showed, there's a link between higher dividend payouts and higher earnings growth. Why? One reason is that when company management teams are forced to dole out a portion of earnings each year as dividends, they have to be more deliberate in choosing value-creating projects and have less chance to "empire-build" with shareholder cash.
Taking the test
To be fair, some companies are better than others when it comes to returning shareholder wealth. That's why it's essential to study your company's track record of both dividends and buybacks.
To do this, read the financial statements to determine:
- Has the company typically employed more buybacks or dividends?
- How has their buyback timing been? Have they frequently repurchased overvalued shares?
- Has the dividend growth rate kept up with earnings growth?
For example:
| Company | Buybacks
2008* | Buybacks
2009* | 5-year
dividend
growth rate | 5-year
EPS
growth rate |
|---|
| Diageo (LSE: DGE) | £1,086m | £392m | 5.4% | 4.5% |
| GlaxoSmithKline (LSE: GSK) | £3,725m | £57m | 7.7% | 9.8% |
| Tesco (LSE: TSCO) | £775m | £265m | 11.7% | 11.5% |
*Last fiscal year -- data provided by Capital IQ, as of 14 March, 2010
As you can see, while each of these companies slowed their buybacks in their fiscal 2009, they've also maintained a good long-term dividend growth rate versus earnings growth -- an encouraging sign.
Foolish bottom line
The myth that dividend paying companies cannot possibly be growth companies is just that: a myth. Instead, shareholder value is maximised by prudent capital allocation decisions made by management and the board of directors. Dividend payments contribute to -- not detract from -- these efforts.
More from Todd Wenning:
> US Fool analyst Todd Wenning enjoys watching his dividends roll in. Todd does not own shares of any company mentioned. You can follow him on Twitter.
