Powerful Payouts

This article has been updated since its initial publication on June 13, 2003.

Anyone who's read my past articles or viewed my portfolio is aware of my fondness for dividend-paying stocks. Today, we'll cover why dividends matter and why current stock yields are more appealing than some think.

It's no secret that dividends have been somewhat back in vogue since the market downturn of 2000. But, despite the harm many suffered at the hands of the go-go market, dividends -- and the companies that pay them -- still don't seem to get the respect they deserve.

Indeed, until recently, even the tax cut on dividends failed to garner much attention for these stocks. Over the last few years, some have gone as far as to say that today's stock yields are so low that they're not worth bothering with.

Here's a good reason not to believe that view: It's malarkey. OK, maybe my calling the point malarkey doesn't quite constitute a good reason, but there's a little data to back me up here.

Fatty and skinny
Today's 1.5% yield on the S&P 500 may sound pretty scrawny, especially when you compare that to its historic 3.5% yield. But that yield can be downright juicy when you look at the alternatives. For instance, the prime rate hasn't been this low since 1958 -- nearly 46 years ago. And, despite a recent surge in bond yields due to fears that higher interest rates are ahead, the S&P mark still beats the 1.2% yield of the one-year monthly treasury average and is more than the 1.37% you could earn on a money market fund.

Better still, there are many companies that have yields closer to the S&P 500's 3.5% average yet still possess market-beating growth potential. Some, like Merck (NYSE: MRK  ) -- which was recommended to readers of Motley Fool Income Investor back in February -- may be fairly obvious to the average investor, but many other opportunities are still out there on the fringes of the market.

Now, because of the added risk, stock yields should be higher than the yields of the investments that I mentioned above. Treasury securities are, after all, guaranteed by the U.S. government, which means there is little risk of default. But, as with all bonds, you can still lose a large amount of principal value in a rising interest-rate environment. On the other hand, dividend-paying stocks would likely suffer less in the same environment.

The real point, however, is that the spread between the yields mentioned here is still wider than it has been historically. This means that, in relation to comparable investments, stock yields are still quite compelling, particularly if you do some digging.

Also, with more conservative opportunities for income drying up, I continue to believe that investors looking to maintain their current lifestyle in retirement will ultimately find equity yields too good to pass up. Especially when they realize that, with money market yields at their current levels and a conservative inflation estimate of about 2.25%, they're losing nearly 1% of their purchasing power each year that their money sits in the bank. That's hardly the road to happiness in your golden years.

When you couple that with recent tax legislation allowing you to keep a bit more of those stock dividends in your pocket, you've got a reasonable case for becoming a dividend fan.

The image problem
"But wait," you say. "I'll have to sacrifice growth if I go after dividends." Not true. Don't believe the image of dividends being for boring, stodgy folks who are completely risk-averse. Dividend companies are not just for your granddad, though there's every reason he should own them, too.

This image primarily comes from the view that dividends are paid only by companies experiencing slowing growth, or by mature companies in industries on the decline. As is so often the case, perception doesn't equal reality.

The truth is that dividends require a successful company to make more efficient use of its capital. For example, let's assume a company called DivPayer Corp. (ticker: CHEK) is doing very well, generating a great deal of free cash flow from operations. It is currently evaluating three projects that are available for investment. Projects A, B, and C offer returns of 10%, 8%, and 4%, respectively. The fact that DivPayer must pay out a cash dividend each quarter means that it only has enough free cash to invest in two of the three projects.

In this example, DivPayer would choose projects A and B because of their higher returns. A company that pays no dividend, however, may have enough funds left over to also invest in project C, despite it being an inferior investment.

This is a simple example, but you'd be surprised at how accurately it can depict a company's decision-making process. The projects available to a given firm will generally have diminishing returns, and companies that pay a dividend are less likely to choose inferior projects simply because they have the money lying around to invest in them.

Certainly, some firms have stricter methods for choosing investments. But the fact is, many companies will simply spend the money because they have it, investing in projects that lower overall returns.

Proof and pudding
Need proof? Numerous studies have demonstrated that dividend-paying stocks have outperformed their non-dividend-paying brethren over the years. One such study by Kathleen Fuller and Michael Goldstein showed that, since 1970, dividend-paying stocks achieved a monthly return of 1.4% vs. 0.9% for their stingier counterparts.

More than that, as my fellow Fools have pointed out, dividend income provided more than 40% of the total return of the S&P 500 over the past 75 years, and dividend payers made their contribution while providing little more than 10% of the volatility contributed by non-dividend payers.

There have also been 10-year periods where dividends have provided the only return for the S&P 500. Even in the latest bull market, the lowly dividend provided 10% to 20% of total returns. Who cares about paying a few extra bucks in taxes to achieve those kinds of benefits, especially when dividends are likely to represent an even larger portion of your total returns in this uncertain environment?

In the end, it's clear enough to me that dividends allow an opportunity to have your cake and eat it, too. If I can satisfy my growth requirements -- and I can, as even the likes of Microsoft (Nasdaq: MSFT  ) have been rapidly growing their payouts -- then why go without the pocket money?

Mathew Emmert is the author of Motley Fool Income Investor, where he shares two dividend-paying stock ideas each month. Sign up for your free 30-day trial here. He owns shares of Microsoft. The Fool has an investor-friendlydisclosure policy.


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