How can you tell whether or not a company's management team is aligned with shareholders?
According to research by Randall Morck and Bernard Yeung, it's not by insider ownership, share repurchases, or a willingness to throw toga parties on the company dime. Instead, a company's dividend policy will tell you whether your investment dollars are in good hands.
And that makes sense
When companies are paying out just a few dimes per year in dividends, it's easy to overlook this shareholder reward. But as Morck and Yeung note in the paper, dividends do far more than put money in your pocket. They are also:
- A strong signaling device about future profits
- A control against management's empire-building
- An indication of the quality of corporate governance.
In other words, companies with a history of paying rising dividends generally possess the traits that make for strong and lasting public companies.
Why dividends matter so much
The cash to pay a dividend has to come from somewhere. The only sustainable place is a company's operating cash flows. As a result, a company that pays a strong dividend is forced to make more careful choices on which projects to fund and which ones to reject in order to maintain the payment. That makes it far tougher to establish "boondoggle" projects that waste money and don't really add shareholder value to pass scrutiny.
Additionally, because dividends are announced and paid on a per-share basis, they help limit excessive stock options grants. After all, more options means more shares, and more shares mean higher total cash outflow to make the same per-share dividend payments.
That's a powerful incentive to limit options grants to people who deserve them.
Mere payment is not enough
Simply looking for a robust dividend payment, however, is not enough. That payment needs to show regular growth.
Of course, dividends do cost money -- cash that could otherwise be used to build the business. As a result, while a dividend needs to be strong enough to encourage discipline, it also needs to leave enough cash for the company to keep growing. Maintaining the right balance is critical for assuring both the health of the company and the wealth of its owners.
Experience suggests that a payout ratio between 30% and 60% of earnings tends to provide the right balance. These companies are just a handful of ones that fit the bill on both growth and payout, while still providing their owners a decent current yield on their investments:
|
Company
|
Payout Ratio
|
Year-Over-Year
Dividend Growth
|
Current Yield
|
|
Genuine Parts (NYSE: GPC)
|
48%
|
8.1%
|
3.2%
|
|
McCormick (NYSE: MKC)
|
45%
|
11.4%
|
2.3%
|
|
General Electric (NYSE: GE)
|
50%
|
12.0%
|
3.3%
|
|
Anheuser-Busch (NYSE: BUD)
|
45%
|
11.9%
|
2.5%
|
|
Rohm and Haas (NYSE: ROH)
|
46%
|
12.1%
|
2.7%
|
|
Emerson Electric (NYSE: EMR)
|
39%
|
14.1%
|
2.1%
|
|
Pfizer (NYSE: PFE)
|
54%
|
20.8%
|
5.6%
|
Data from Capital IQ.
Exercise your power
As a small investor, you may never have direct control of the executives of the companies you own. By paying attention to the dividend policies they set, though, you can get a crystal-clear picture of how they treat shareholders.
At Motley Fool Income Investor, we understand the tremendous power of dividends. Our market-beating performance shows just how well you can do by investing in companies that are built to reward shareholders. If you're ready to do just that, join us free for 30 days. You can see all our research and specific recommendations and be under no obligation to subscribe.
At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric. Anheuser-Busch and Pfizer are Motley Fool Inside Value selections. The Fool has a disclosure policy.
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