The valuation of a company is based on the money it earns for its owners. If you were to sell your corner shop as a going concern, the price you’d get would be based on the profits it generates. In the case of a corner shop, those profits would usually be taken out by the owner to live on.
The same is true with a quoted company on the stock market, if it is one that is mature, has nowhere to realistically expand, and is paying out its profits as dividends — just as our corner shop would be valued on the profits that the owner can take out of it, the value in such a company would be based on its dividends.
In reality, it is possible to all businesses as being valued in a similar way. The value of a company that is not paying a dividend can be seen as being ultimately dependent on its potential future dividends. The greater the profits it will make through expansion today and which it could pay out as dividends in the future, the greater the value of the company today.
And that’s true even if a company never plans on actually paying out any dividends, as it is the potential ability to pay out dividends that counts. Take, for example, Berkshire Hathaway, the investment company managed by the legendary Warren Buffett and Charlie Munger. Paying dividends is not part of Berkshire Hathaway’s strategy (the managers would pay out money as dividends if they thought they couldn’t add more value by reinvesting the cash, and to date they have been very successful at that), but still the shares have spent decades growing in value (way beyond anything any bank account could have managed).
The value of Berkshire Hathaway is related to the money it could pay out as dividends if it took all the growth in value of its underlying holdings each year and paid them out that way. So Berkshire Hathaway shares have a value and can be traded, even if none of the underlying investments are ever handed back to shareholders as cash.
With a company that is paying dividends, we can use that dividend as an indicator of its value (bearing in mind the proportion of its profits that are also retained for future growth).
One handy number is a company’s dividend yield, which is simply a way of expressing its dividend as a percentage of its share price. If a company has a share price of £1, and it pays out a dividend of 6p per share, its dividend yield will be 6/100, or 6%. Dividend yield can be an especially valuable way of comparing investments in economic hard times when savings accounts are paying such low rates of interest — such times make the value of a company’s dividends look especially tempting, providing we understand the difference in risk.
The risk associated with saving your money in a bank account that pays, say, 3% gross is very low, despite the banking problems we have seen in the past year or so (and is even lower if you have no more than the government-guaranteed £50,000 deposited with any one qualifying institution). You’re going to get the 3%, because it is applicable today (and if it changes in the future, you can re-assess the situation easily), and your capital is safe.
If, however, you instead invest your money in a stock with the expectation of getting 6% the next time it pays a dividend, your risk is twofold.
Firstly, the next dividend is not guaranteed, and a company can decide to pay out less (or even nothing) if it ends up not earning enough. Also, the value of your capital can fall, In fact, if you hit the first problem, a reduced dividend, a fall in the share price is likely to follow.
The trick to using dividend yield as an indicator of the value of a company is partly to see it as only one tool in our investing armoury and consider other valuation measures too, and partly to carefully consider whether a given company’s expected dividend is likely to be maintained.