In order to survive, companies are expected to make profit at the end of each reporting period — three months in the US and longer periods in other countries. The management of each company decides what they want to do with this profit. The three common alternatives available are: (1) pay some or most of it as a dividend to the shareholders or (2) channel it back to the business in order to grow it further or (3) use it to buyback their company shares. Many companies choose to diversify and accordingly spend their income on more than one of the above alternatives.
Dividends can be either cash or stocks. A cash dividend is usually paid out from net profit that the company has generated from the previous period. The percentage of net earnings that the company uses to pay its dividends is called payout ratio. The amount of the dividend divided by the share price represents the yield of the company, normally reported in percentage. The yield varies from zero — no dividend, up to around ten percent. At bull market peaks in the US average yield bottom-out at 2.5 to 3 percent, while at bear market minimum the average yield rise to over 6 percent. Slow growth companies such as electric utilities and real estate investment trusts (REIT) usually provide high yield. Stock prices of companies that have a high yield are usually stable — does not fluctuate much. Historically people were attracted to high yield companies. With the expansion of high technology during the last two decades of the 1900s, the preference has changed to growth companies that can provide consistent stock price appreciation. This percentage appreciation in stock price has usually been higher than the yield of dividend paying companies.
A stock dividend may also be used to give the shareholders additional shares, instead of cash, in amounts such as 2 percent to10 percent. Stock dividends are often used to conserve cash needed to operate the business. Unlike a cash dividend, stock dividends are not taxed until sold. After a dividend is paid, the stock price will adjust in the same way as for a stock split. A stock that pays a 10 percent stock dividend usually drops by 10 percent on ex-date for the stock dividend.
Instead of paying dividends, many companies plow their profits in expanding their business, buying new equipment and improving old machinery. Normally the share prices of such companies are more volatile, however they tend to grow much faster. Typical of this group are technology and high growth companies.
During the 1970s, industrial corporations in the developed countries would distribute about 40 percent of their earnings as dividends and 2 percent of earnings would go toward shares’ repurchase. During the 1990s, the repurchase percentage grew to about 20 percent of earnings while the dividend layout percentage fell only slightly. Repurchases have become the preferred alternative to dividends because the tax benefits to shareholders.
A valuable vision of dividends surfaced in the mid 1930s by John Williams in the US who said, “Earnings are only a means to an end, and the means should not be mistaken for the end. Therefore we must say that a stock derives its value from its dividends, not its earnings. In short a stock is worth only what you can get out of it”. Dispensing profits to shareholders was what a corporation was for, and that’s how things remained for centuries. From 1871 to 1980 dividends accounted for almost 80 percent of the US stock markets’ inflation-adjusted return to investors, according to Wharton School market guru Jeremy Siegel. Over the years, an alternative to the dividend has emerged namely the stock buyback. This is a flexible, tax-efficient way of getting money to shareholders.
Investors are under the impression that due to their elevated risk, high-tech companies provide better return than the boring slow moving utilities companies. In fact the Standard & Poor’s Utility index outperformed the tech-laden NASDAQ Composite Index over a five-year period starting the end of 1995. Including dividends, the utility index showed a 7.8 percent average annual return, versus 6.7 percent for the NASDAQ. The difference becomes more apparent in a bear market, when the dividend dominates the little or no appreciation in the stock price. In simple terms the stock price of a company that pays dividend of say 2-5 percent a year, usually appreciates by 3-5 percent a year thus providing an annual return of 5-10 percent. A company which does not pay dividend normally appreciates by 3-11 percent a year.
(Salim J. Ghalayini is a professional engineer and a seasoned investor. He manages several investment accounts.)
