Why Dividends Make Sense

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Here's a question I had thrown at me the other day: "Why invest in dividend-paying stocks?"

It was immediately followed by: "I expect a company to reinvest all of its cash for more growth."

This isn't an uncommon line of thought, and it's not a question or statement without merit. There are great companies that should absolutely plow all of their earnings back into their business. For years, Starbucks (Nasdaq: SBUX), Microsoft, and Costco (Nasdaq: COST) were this way. But times change, and in the past couple years, Microsoft and Costco have initiated dividends. Starbucks is now throwing off so much cash that it can buy back substantial amounts of shares and finance its growth, and it appears the coffee behemoth could easily initiate a dividend.

It's a common perception that dividend-paying companies are mature slow growers. But that's just not always the case. Paying a dividend can be the sign of a responsible management team that sees growth in front of it -- but more cash than it needs to execute that growth in a controlled fashion. Costco fits that mold. You could make the argument that Abercrombie & Fitch (NYSE: ANF) does as well.

All things aren't equal
In theory, a company should plow all of its free cash flow back into the business for additional growth until it reaches the point that it is no longer able to do so. But in the real world, management teams don't always allocate their capital properly. When it reaches the point that it no longer makes sense to invest all of its earnings into the core business, management might start to reach for growth that is beyond its grasp. If a company chooses not to initiate a dividend, it has a few other options in its quest to reward shareholders. It can make acquisitions in hopes of adding growth (most likely reaching), it can buy back shares, or it can let the excess cash sit in the bank.

Going down the acquisition path is the most daunting. Not only does the company need to pay the right price, but it also needs to operationally and culturally absorb the other business in order to add value for shareholders. Time Warner (NYSE: TWX) learned this lesson with AOL, and it looks to me like eBay (Nasdaq: EBAY) will learn this lesson with Skype.

Share repurchases can be a great way to return value to shareholders, but the company must be opportunistic and it must understand when its shares are undervalued. Perhaps most importantly, in order for a share repurchase plan to truly benefit investors, it needs to be greater than the number of options issued. That's no small feat. Coach (NYSE: COH) is a rapidly growing company with very strong free cash flow and a share repurchase plan that it executes, but those repurchases are far outweighed by the dilution from stock options. (That's not to say that the dilution is unreasonable, given the performance of the company.)

Last up is to simply sit on the cash. Great option ... if you're Warren Buffett or have his abilities for allocating capital. Sadly, most of us -- and most of the people running companies that are responsible for investing capital -- do not either. Cash sitting in the bank is better than a bungled acquisition, but neither makes as much sense as a dividend.

Foolish final thoughts
No matter the strategy -- growth, value, income -- the goal of investing is to build wealth and outperform the market. Valuation and growth are paramount, as is the quality of the underlying business. If we can get those three things and receive a 3% or more dividend yield, we're about one-third of the way to a market-beating return without any appreciation in stock price.

This happens to be exactly the formula that Mathew Emmert has put to work in our Motley Fool Income Investor service. A full 70% of Mathew's recommendations are beating the market, including AmSouth Bancorp (NYSE: ASO). Since its recommendation two years ago, AmSouth and its near-4% yield have returned a total of 32.3%, against the S&P 500's 25.7%.

Interested in learning more about companies that generate robust free cash flow and pay you to hold them? C onsider a free 30-day trial to Motley Fool Income Investor. Over the past two-plus years, Income Investor selections have delivered a total average return of 16.1%, vs. the S&P 500's 9.7%. There's no obligation to buy if you aren't completely happy.

Nathan Parmelee owns shares in Costco and Starbucks, but has no financial interest in any of the other companies mentioned. You can view his profile here . Costco, eBay, and Time Warner are Motley Fool Stock Advisor recommendations. The Motley Fool has an ironcladdisclosure policy.