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More Proof That Companies Shun Dividends at Their Own Peril

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Some investment rules are so powerful they can't be rebutted with a straight face. That companies with higher dividends tend to outperform those with lower dividends is one of them. One thousand dollars invested in the S&P 500 in 1957 was worth $176,000 in 2006. The same $1,000 invested in the top 10 S&P companies with the highest dividend yields was worth $1.3 million. Countless academic studies show that dividends are typically the best way companies can reward shareholders. None that I know of argue the opposite.

But you'd never know this by looking at the behavior of corporations. For half a century, they've been distancing themselves from dividends with a passion. The dividend payout ratio -- the percentage of earnings companies pay out as dividends -- for the S&P 500 is now at the lowest level in recorded history, less than half its historic average. Since 1990, S&P 500 earnings have grown more than fivefold, yet dividends have merely doubled.

There are all kinds of reasons companies might be shunning dividends. Management often thinks it can use earnings more efficiently on acquisitions (few can), or put it to better use on share buybacks (rarely works).

Another popular explanation is that more CEOs are being compensated with stock options, which lose value when a dividend is paid. By not paying a dividend, cash stays inside the company, increasing the net worth of the business and raising its stock price and the value of a CEO's stock options. CEOs are incentivized to avoid dividends, some say. They want shareholder returns to come from rising stock prices, not dividends, even if it means a smaller total return.

The theory makes sense, and could explain part of why dividends have declined so dramatically. CEOs are just doing what they're incentivized to do. But if avoiding dividends in the name of a higher stock price is their intention, there's evidence that it's backfiring.                        

I took the 500 companies in the S&P 500 and ranked them by dividend payout ratio, and then looked at the average P/E ratio of each quintile. What it shows might surprise you. Companies that pay the most dividends tend to have higher P/E ratios:


Average P/E Ratio

Highest dividend payout 19.3
Second highest dividend payout 15.6
Third highest dividend payout 13.8
Fourth highest dividend payout 12.2
Lowest dividend payout 12.6
No dividend 17.2

Source: S&P Capital IQ, author's calculations.

Now, the group that pays no dividends (129 companies in the S&P 500) actually has a pretty high P/E ratio. This makes sense. A select group of companies are very good at investing in themselves and create a lot of value without paying dividends. The group includes some of the highest-quality, best-run companies in the world, names like Amazon (Nasdaq: AMZN  ) , Chipotle Mexican Grill (NYSE: CMG  ) , and Berkshire Hathaway (NYSE: BRK-B  ) . These companies shouldn't pay dividends because they can invest money more efficiently than most of their shareholders, and the market knows it.

But they are the exception. For the majority of companies, there's a clear trend: pay higher dividends, and the market will reward you with a higher P/E ratio.

Some examples of this are almost comical. Consolidated Edison (NYSE: ED  ) is a slow-growing utility and has a P/E ratio of almost 17. Microsoft (Nasdaq: MSFT  ) is growing briskly and has a P/E ratio of less than 10. AT&T trades at about the same P/E ratio as Apple, even though Apple's growth potential is unquestionably greater.

How can this be? The best explanation is that Edison and AT&T pay out most of their earnings as dividends, while Microsoft and Apple offer low or no payouts. Investors still pay up for earnings and growth, but they'll trip over themselves for dividends. Starving for yield with bonds returning close to nothing, this isn't surprising. Even if interest rates were at normal levels, companies that pay low dividends should be discounted relative to high-paying companies, since there's such a widespread and consistent history of management squandering cash while attempting to "grow" their business.

These numbers should also add a twist to the idea that CEOs are avoiding dividends in order to increase the value of their stock options. That might be their intention. But the opposite, it seems, is actually happening. Most companies could increase their stock price -- and hence the value of executives' stock options -- by paying higher dividends.

Most, however, won't. CEOs will keep deluding themselves into thinking they have the Midas touch in deal-making or have a knack for stock buybacks. The irony is that coming to terms with the fact that they don't wouldn't just help outside shareholders -- it'd help their own paychecks.

Looking for a few high-quality dividend stocks for your own portfolio? Check out The Motley Fool's special report, "Secure Your Future With 11 Rock-Solid Dividend Stocks." It's free. Just click here.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway, Edison, AT&T, and Microsoft. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of, Chipotle Mexican Grill, Microsoft, and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of, Microsoft, Berkshire Hathaway, and Chipotle Mexican Grill. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. 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 (18) | Recommend This Article (74)

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 January 04, 2012, at 5:22 PM, TMFRoyal wrote:

    Thanks, Morgan. Great point.

    You've said it before about MSFT, and I think it bears repeating: the best way for MSFT to increase its share price would be to double that dividend. It has only a 23% payout ratio now, so it's eminently possible and the company would still have a conservative payout ratio with room for growth.

    You think investors would sit on the sidelines for MSFT with a 6% yield? Heck no. Plus a higher payout keeps management from exploiting its all-too-keen ability to blow cash with abandon.


  • Report this Comment On January 04, 2012, at 5:26 PM, xetn wrote:

    Perhaps there is another reason companies are "shunning" dividends: self-funding growth. In an era when banks are basically loaning almost exclusively to the Fed (in the form of excess reserves at about .025%) the companies retain sufficient working capital to fund future growth without incurring interest expense. I know, interest is deductible right? So what? It is still an out-of-pocket expense unlike such non-cash expenses as depreciation.

    Not sure if this is really going on, but it remains a possibility.

  • Report this Comment On January 04, 2012, at 5:37 PM, modeltim wrote:

    This is the main reason I won't put a nickel in AAPL.

  • Report this Comment On January 04, 2012, at 5:44 PM, colleran wrote:

    Excellent article. One of the best I have read on the Fool. We are in the era of CEOs that think they are God's gift to mankind. I think it may have started with Lee Iacocca at Chrylser. And just look how Chrysler turned out. Everyone is looking for a miracle-worker as CEO and many CEOs agree with that sentiment. Until stockholders like us stop this insanity, companies like Microsoft are going to continue to squander our money in search of the Holy Grail. We need to start making public which companies need an infusion of reality. Occupy CEO Land, anyone? Anyway, keep up the good work Morgan.

  • Report this Comment On January 04, 2012, at 7:02 PM, TMFBreakerRob wrote:

    Well said, colleran.

  • Report this Comment On January 04, 2012, at 7:28 PM, F111epilot wrote:

    As one of the uneducated. I only invest in companies that dole out dividends. Thus when their price falls, I still make something. With few exceptions I've found most CEOs are part of the old boy network, doing what's best for them and "the hell with the stock holders". Can some buddy say. Golden parachute! Regardless of the poor decisions the CEO makes. He gets rich

  • Report this Comment On January 05, 2012, at 2:06 AM, promommyfool wrote:

    I started out avoiding dividend companies becasue my early stock training (4 hour seminar) said if I traded well that wouldn't matter. I'd make more without it.) Must not have done it right cuse I didn't grow like wildfire when I invested by the book.

    Now I invest on a totally different set of rules and look for over all strong companies that don't have to be watched on a daily basis for wild buy and sell signals. Companies much more stable with good dividends.

  • Report this Comment On January 05, 2012, at 10:40 AM, cloggervic wrote:

    A huge reason for not paying dividends is that they are quadruply or even quintuply-taxed: Company profit is taxed first at around 40% (state+federal), then when what's left is distributed to shareholders, they are taxed at between 23% and 43% (state+federal), or more if they are unfortunate enough to be retired and paying means-tested medicare charges, which is yet another tax on income.

    By retaining profit, only corporate (state+federal) tax is payed, and the retained profit theoretically increases book value and shareholders beneoft ultimately by capital gains, which do not have to be realized all at once, or can be acquitted against capital losses.

    This is one area where the tax code is very bad for the economy, by motivating CEOs to manage their companies in a way that is less than optimum. Another area is that the tax code does not allow CEO remuneration over $1m to be deducted as an expense: It has to come out of profit. Congress's theory is that that will make sharehodlers control excessive CEO pay. But it doesnlt work: The majority of shareholders are institutional (e.g. Goldman Sachs) , and they are paying themselves excessively too. So what is needed is to make all CEO pay a deductible expense for the company, but to tax remuneration over $1m at a swingeing rate such as 75% from $1m to $2m and 110% over $2m

    (or put your own numbers in there)

    (Note this would not apply to income from capital but would apply to remuneration by stock options and the like - the point is not to stop CEOs, who are just employees that have no boss, setting their own pay and looting the company)

  • Report this Comment On January 05, 2012, at 10:45 AM, cmfhousel wrote:

    ^ I understand the double-tax argument on dividends, but frankly, every dollar in the economy is double, triple, or quadruple taxed. I earn a dollar of income, and it's taxed. I spend it on stuff, and I pay sales tax. I buy a house with it, and pay real estate tax. I spend it on something that gives a business profit, and they pay income tax on it. They use it to pay their employees, and pay payroll tax. The employee pays income tax, and uses what's left to buy stuff, where they pay sales tax, etc etc. Every dollar is a neverending loop.

    Further, citing taxes as a reason companies are paying lower dividends doesn't make much sense: companies paid much higher dividends during a time when dividend taxes were much higher.

  • Report this Comment On January 05, 2012, at 10:59 AM, truman1987 wrote:

    Nice article. Makes sense of course. A company that pays a dividend has to stay focused.

    You mention stock buy backs as rarely working. I've always considered stock buy backs to be a sell signal. They indicate uninspired management. For a company to buy its own stock means that after analyzing all the places it could invest its money, including paying a dividend, management picked their own company? Either that or they are trying to juice the stock price short term.

    Morgan, do you know of any studies that would show statistically what happens to a stock price a year or two after a stock buy back?

  • Report this Comment On January 05, 2012, at 11:03 AM, cmfhousel wrote:

    <<Morgan, do you know of any studies that would show statistically what happens to a stock price a year or two after a stock buy back?>>

    None that I can think of. Some companies are good at buybacks ... most are pretty bad. Buybacks peaked in late 2007 as markets topped, and fell ~80% as stocks became cheap in 2009. Happens again and again.

  • Report this Comment On January 05, 2012, at 8:56 PM, mikecart1 wrote:

    Not dropping a penny in AAPL because dividends protect you when a good thing becomes just ok. When AAPL stops playing God in the cell phone world, look out. That $400/share price can follow RIMM which didn't pay a dividend either. In contrast, look at any solid 4% company like BP. When times are bad, you can average down knowing the dividend will return to greatness.

  • Report this Comment On January 05, 2012, at 11:45 PM, Edeskimo wrote:

    For those arguing that buybacks don't work - you are wrong. Stock buybacks do tend to be a positive so long as they are not diluted in stock options for the employees and management. It has to be a true net buyback.

    So long as the company is using actual earnings and believes the company is a good bargain compared to the general market then a buyback is a tax efficient use of that income.

    There is actually a stock buyback achievers index. For a company to qualify I believe they have to have bough back 5% of shares in the last year (or was it 5%/yr over 3 years). When compared to dividend achievers, the dividend buyback group actually had a better overall total return. Some companies actually belong to both lists. I think one should add buybacks to dividend to calculate the combined yield. This would eliminate companies that pay out dividends by selling new stock which is dilutive of the company.

  • Report this Comment On January 05, 2012, at 11:51 PM, cmfhousel wrote:

    <<So long as the company is using actual earnings and believes the company is a good bargain compared to the general market then a buyback is a tax efficient use of that income.>>

    Agreed! But many, many companies a) use so much cash buying back stock when times are good that they have to puke up shares at low prices to raise cash when times are bad, and b) might think the company is a good bargain, but are usually mistaken. Repeating above: Buybacks peaked in late 2007 as markets topped, and fell ~80% as stocks became cheap in 2009.

    Some companies do it well. Most don't.

  • Report this Comment On January 06, 2012, at 12:52 PM, MCrawley1970 wrote:

    I agree that most companies don't manage share buybacks well, in much the same fashion as most tend to overestimate the benefits of mergers and acquisitions.

    Going one step further, I have often suspected that buybacks, in some cases at least, may be used as an "artificial" means by which to boost Earnings Per Share, without any real improvement in the disposition of the company in question. Are there any good cases studies that validate my suspicions?

  • Report this Comment On January 06, 2012, at 1:55 PM, truman1987 wrote:

    Interesting, looking into Edeskimo's comment, there is an ETF that indexes on companies that buyback shares. "The PowerShares Buyback Achiever Portfolio is based on the Share BuyBack Achievers Index, which consists of U.S. companies that have repurchased at least 5% or more of outstanding shares during the trailing 12 months. "

    According to what I read it has outperformed the Russell 3000 and S&P500 over the last 3 years. It's only 92 stocks so it isn't a large sample set. It looks like if the company slows down the buyback to below 5% then they drop off the list in 12 months.

    I would expect there to be a short term juice to the stock prices as it will improve ratios. However, I think it indicates a lack of creativity of the management team. I'd like to see after 2 or 3 years where the stock price is. I'll bet it is underperforming.

  • Report this Comment On January 06, 2012, at 6:39 PM, TMFRoyal wrote:

    Hey, MCrawley,

    In answer to your question, look at KMB, which I covered in this article:


  • Report this Comment On January 17, 2012, at 4:51 PM, thidmark wrote:

    "but frankly, every dollar in the economy is double, triple, or quadruple taxed."

    Amateur economist George Harrison famously commented on this absurdity ...

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