The Big Dividend Heist

You hear all kinds of reasons for why stocks should perform badly in the coming years. We'll have another recession. Inflation will take off. There will be a debt crisis. America will fall behind the rest of the world.

All could happen. But there's something simple American corporations could do today that would dramatically boost the appeal of the stock market: increase the dividend payout ratio back to historic averages.

The dividend payout ratio -- dividends as a percentage of earnings -- on the S&P 500 Index has plunged to its lowest level in modern history. The current payout ratio, 29%, is less than half its long-term average:

Source: Robert Shiller, Yale, author's calculations.

The plunge has caused all sorts of confusion and irrationality, namely that low dividend yields are a sign of an overvalued market. Last December, widely followed perma-bear analyst David Rosenberg warned:

From a historical standpoint, the yield on the S&P 500 is very low -- too low, in fact. This smacks of a market top and underscores the point that the market is too optimistic in the sense that investors are willing to forgo yield because they assume that they will get the return via the capital gain.

But this overlooks the collapse of the payout ratio. If today's ratio were at its long-term average, the S&P 500's yield would be nearly 4%, which happens to be the average yield from after World War II until the early 1990s (before the dot-com bubble skewed yields).

Companies could (and do) argue that investing in the business is preferable to paying dividends since it leads to higher earnings growth. While this might be true in some cases for some companies, on average the data doesn't back it up. One 2006 study found that "contrary to popular wisdom, the greater the proportion of earnings paid out as dividends, the greater the subsequent real earnings growth." For every period of strong earnings growth paired with a low payout ratio (late 1990s), one can point to a period of strong earnings growth paired with a high payout ratio (1910s, 1920s). Investor Cliff Asness looked at how current payout ratios relate to future earnings expectations. No luck here, either: "The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low."

How can this be? It's likely that corporations choosing to invest cash rather than pay higher dividends end up overpaying for assets. Acquisitions are nearly always done at premium valuations, and stock buybacks are well-documented to only become popular at precisely the wrong time: when share prices are at their highest.

In all likelihood, today's market would welcome higher payouts. Last year, renowned value investor Bill Miller noted that telecom is one of the slowest growing industries, yet trades at one of the highest valuations. His explanation for this puzzle was simple: "It has a high dividend payout ratio, which is why it trades where it does." AT&T (NYSE: T  ) actually trades at about the same forward earnings multiple as Google (Nasdaq: GOOG  ) . Similarly, the snail that is Consolidated Edison (NYSE: ED  ) trades at a richer multiple to earnings than the dynamo that is Apple (Nasdaq: AAPL  ) . These companies come from vastly different industries, so apples-to-apples comparisons might not be apt. In general, though, it's clear that investors are willing to bid up valuations in exchange for yield. As they should. Have you seen bond yields lately?

So if it's obvious, why don't more companies increase dividends? A tepid economy could promote the desire for businesses to hoard cash. But this is more self-fulfilling than it is rational. A major reason the economy is tepid is because businesses are hoarding. The incentive arrangement between management and shareholders can also be skewed: Empire building through acquisition can increase executive compensation even if it comes at the expense of earnings.

Run through all the excuses, and none stack up to the most powerful argument for higher dividends, outlined by value investing great Ben Graham in his classic book The Intelligent Investor: "The profits 'belong' to the shareholders, and they are entitled to have them paid out within the limits of prudent management."

Interested in dividend stocks? Click here for free access to The Motley Fool’s special report 13 High-Yielding Stocks to Buy Today.

Fool contributor Morgan Housel owns shares of Consolidated Edison. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Google and Apple. Motley Fool newsletter services have recommended buying shares of Google, AT&T, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (14) | Recommend This Article (34)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 31, 2011, at 4:12 PM, Borbality wrote:

    Why pay others when you can pay yourself? Where is all the money going to go instead? bonds? yeah right!

    Also i'd like to think a nice dividend and higher (but still healthy) payout ratio means a company is managed well enough to do these things, rather than desperately trying to attract investors. Makes sense on some level that these companies have done well, because they have to SHOW YOU THE MONEY with real dividend payments.

  • Report this Comment On May 31, 2011, at 5:33 PM, drborst wrote:


    As usual, some really interesting data. But I'm not sure I see the same thing you do. I look at the plot and see a downward trend from 1940 to present (by the way, I'm assuming the bar labeled 1940 is for 1940-1949), with an odd ball post tech bubble from 2000-2009.

    Why is that interpretation of you plot wrong?


  • Report this Comment On May 31, 2011, at 5:42 PM, cmfhousel wrote:

    ^ Nope, you're right. The trend has been down for decades. The only reason there's a bump from 2000-2009 is because earnings collapse late in the decade. Still, the trend doesn't make it any more justified. Obesity has been rising for decades ... doesn't make it desirable.

  • Report this Comment On May 31, 2011, at 5:44 PM, xetn wrote:

    So, are these companies accumulating cash? If, as we hear, that the banks are not lending. maybe the companies are "lending to themselves". I don't know the answer, just asking a question.

    Anybody have an opinion?

  • Report this Comment On May 31, 2011, at 6:11 PM, aptosjoe wrote:

    Tell that to Buffet who has never paid a dividend and never intends to. What is the point of owning a company like that. Ahh he says, I return more by using your money to increase value. But what if investors refused to buy a stock that would never pay a dividend? What would it's 'value' be?? Zippo.

    Look Ma, the King is naked!!

  • Report this Comment On May 31, 2011, at 6:32 PM, GregLoire wrote:

    @ aptosjoe

    "What is the point of owning a company like that."

    Capital gains via increase in value.

    "But what if investors refused to buy a stock that would never pay a dividend? What would it's 'value' be?? Zippo."

    You're using a "what if" scenario that doesn't exist in our world and never will, but here is your answer: The company would likely start paying a dividend. Warren Buffet is talking about the real world, not your hypothetical, non-existent world.

    Let me put this another way. Let's say that Berkshire Hathaway's market cap drops to $10 tomorrow because everyone decides that they refuse to invest in a company that doesn't pay a dividend. I buy the whole company for $10, then decide that the company WILL issue a dividend, and 100% of it goes to me.

    See the problem here? Whether a company issues a dividend is a decision made by the people in charge, not a hard-wired aspect of the stock or company itself.

    If the market suddenly decides that dividends are 100% required for a company to have any value, then there is nothing stopping these companies from deciding to start paying one. The latter doesn't always happen simply because the former doesn't either.

  • Report this Comment On May 31, 2011, at 7:11 PM, TMFDarwood11 wrote:

    So, companies are hoarding cash, giving a relatiely small amount of it to CEOs, etc. and stiffing the investors!

    What I take from this is, stock investors must be more selective. Hmmm. Is that an argument against

    "Index Investing?"

  • Report this Comment On May 31, 2011, at 10:40 PM, skibrendan wrote:

    You seem to have never heard of the "Dividend puzzle." It shouldn't matter if a company's earnings go back into the company or out to the investor. In fact, there's a tax advantage to not paying a dividend: dividends are taxed as income while growth (including earnings driven growth) are taxed as capital gains. A dividend is a good signal a company is not hurting for cash, but it is generally money wasted on the tax man.

  • Report this Comment On May 31, 2011, at 11:26 PM, Eerkes wrote:

    i feel like the repatriation tax has a big part in this, much of the cash on company balance sheets is overseas

  • Report this Comment On June 01, 2011, at 1:47 AM, Nahzuul wrote:

    How does the percentage of company income paid for executive compensation compare from 1900 to the present? Is this a factor in the performance of the stock? Should shareholders be concerned when they see the stewards of their investment paying themselves huge bucks? My subjective observation during my lifetime has been of a decline in honesty and personal accountablity throughout society. Could it be that this model of "We'll take care of the company and by the way we set our own compensation" isn't so great?

  • Report this Comment On June 01, 2011, at 2:10 PM, HMJR wrote:

    @ Eerks

    Good comment on tax repatriation. I would add a segment breakdown, as long it has changed a lot over this long period. Let's take banks in the current period as an example.

    Morgan, nice data for a start, but I think it's still too early to jump to conclusions...

  • Report this Comment On June 02, 2011, at 7:34 PM, TMFRoyal wrote:

    Hey, Morgan,

    Interesting data. The reason for the decline? I think you hit the nail on the head: "Empire building through acquisition can increase executive compensation even if it comes at the expense of earnings."

    Look at the power of incentives, and the attitude of many managers that the cash is theirs and not shareholders'. Charlie Munger's best lesson.

    Foolish Best,


  • Report this Comment On June 03, 2011, at 5:07 PM, mikecoursey wrote:

    "Tell that to Buffet who has never paid a dividend and never intends to. What is the point of owning a company like that. Ahh he says, I return more by using your money to increase value. But what if investors refused to buy a stock that would never pay a dividend? What would it's 'value' be?? Zippo."

    @ aptsojo

    I feel that Berkshire Hathaway and Warren Buffet is rather thee exception in this case and not the rule. Buffet has rock-solid integrity and a no-nonsense management style that is pro-shareholder value NOT pro-management. His compensation packages for all the companies under the Berkshire umbrella are based on long-term metrics and there are penalties for performing poorly against those metrics as well as perks to performing well.

    Add it all up with companies that Buffet acquires adding value to the Berkshire balance sheet and earnings rather than taking value away and yes, it makes sense to let him hold onto the cash so he can reinvest it in great companies rather than pay it back to the shareholders.

    However, many of the companies that are under the Berkshire umbrella pay dividends directly to the conglomerate suggesting that Buffet is NOT anti-dividend.

  • Report this Comment On August 10, 2011, at 7:20 PM, 123spot wrote:

    Came here from the live-chat and learned a lot both places. I'm especially impressed in the explanation Morgan gave for the distortion of perceived historcial dividends because of the changing metric of payout ratios. I can't tell you how long I've been holding off on buying until dividends reached above their historical mean as a marker for fair valuation. Won't get fooled again. Plan to keep getting schooled. Thanks so much. ( I just can't tell you how amazed I am at this revelation.Please keep shining the light, though I admit it hurts to see all of the trickery manifested. Better to know.) Spot

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