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The Danger of Low Dividends

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Earnings among S&P 500 companies are at an all-time high. By quite a bit, too: Operating earnings per share last year were more than 10% above the previous peak set in 2006, when the economy topped out before the recession.

Dividend payouts are also at an all-time high, but there is much less to be excited about here. Companies have been paying out a lower share of their earnings as dividends for decades, and the trend shows little sign of slowing. The dividend payout ratio is pitiful:

Source: Yale, author's calculations.

A lot of this decline over time is explained by companies using more of their free cash flow to repurchase shares. Benjamin Graham's classic 1949 book contains deep analysis and commentary on dividends, but scarcely a mention of share buybacks. That changed dramatically after the 1980s. Legg Masson has shown that from 1985 to 2011, S&P 500 dividends increased fourfold, but share buybacks increased 21-fold.  

The impact this shift has on how investors are compensated is deep. As Shawn Tully of CNNMoney pointed out earlier this year, the dividend yield on ExxonMobil (NYSE: XOM  ) is a little more than 2%, but the total yield including buybacks is north of 7%. Pfizer's (NYSE: PFE  ) dividend yields more than 3%, but with buybacks the company returns 7.6% to shareholders. Wal-Mart's (NYSE: WMT  ) total yield is about double its dividend yield.

There are mountains of evidence showing that, on average, investors are better off with dividends than share buybacks, as CEOs have a terrible history of buying back their shares at nosebleed prices.

But I think the damage of the shift toward buybacks may even be underrated. With interest rates at zero, investors have been clamoring for yield wherever they can find it. For years, that's been stocks with high dividends, whose prices have been pushed to record levels and yields down to near record lows. Shares of Verizon (NYSE: VZ  ) now yield less than 4% and Altria Group (NYSE: MO  ) , less than 5%.

These are still healthy yields, particularly compared with fixed-income alternatives -- and both companies have high dividend payout ratios. But I can't help but wonder whether companies favoring buybacks over dividends will ultimately be a disservice to companies with high dividends. The lack of yield among most stocks drives up valuations at companies that still do provide reasonable payouts, and high current valuations will eat into future returns.

Managers typically cite the desire to "enhance shareholder value" when announcing share buybacks. But never underestimate the power of unintended consequences. 


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Read/Post Comments (17) | Recommend This Article (38)

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 April 25, 2013, at 10:02 PM, GETRICHSLOW2 wrote:

    Give me the dividend. Let me decide what to do with it.

    Buybacks are a scam.

  • Report this Comment On April 26, 2013, at 10:05 PM, SkepikI wrote:

    Buybacks are only a scam if the stock is OVERVALUED. OR, if the CEO and management gets some benefit out of it, like bonuses for stock price increases!!!! which you forgot to mention Morgan... However, I will forgive you that, because of the sage reminder to fools everywhere: "With interest rates at zero, investors have been clamoring for yield wherever they can find it. For years, that's been stocks with high dividends"

    Far better than bonds and bond funds with all the downside risks they entail. Hurrah for CEOs and company managers that press dividends up...a sign of good management.

  • Report this Comment On April 30, 2013, at 5:59 PM, dsliesse wrote:

    I'm not so concerned about the "investors" who clamor for high yields -- they're usually the ones who want to make a quick buck and get out (in other words, they're not at all interested in "investing" in the company but they'd rather "speculate").

    I don't mind a drop in dividends overall if it means that companies are issuing less debt. I was a contrarian throughout my MBA program, and I firmly believe that while there are times when taking on debt is a good strategy (for example, when you can get something now at a price you'll never see again, or you haven't had the chance to accumulate the funds to pay cash in an emergency), it should be minimized. Interest is just a wasted expense.

    Stock buybacks, on the other hand, are the lazy way out. They're just an artificial means of increasing the book value of outstanding shares.

  • Report this Comment On April 30, 2013, at 6:04 PM, comnsense wrote:

    You forget to mention what is better for top management with stock options and earnings goals for bonuses. Price appreciation is better for their self interests rather than dividends to the shareholders.

  • Report this Comment On April 30, 2013, at 6:28 PM, kurtullman wrote:

    These ARE the intended consequences. Since changes in tax laws (ironically enough because Congress thought executives were being paid too much) in the 80s, executives have been paid not to run the company, but to run the stock price. The tax laws cap all actual salaries at around $1 million but encourage stock options. Until the execs are paid on dividends and not stock price, this won't change.

  • Report this Comment On April 30, 2013, at 6:28 PM, vinceroach wrote:

    I was a CEO of a public company that fell on bad times. Our stock got down to way less than book value and we had cash so I scratched and clawed to get the Board to buy back shares. They would not do it so I got them to give me lots of options at the current price. They did, we sold rthe business for 10 times that price and I had to tell the other shareholders "I told you so". When you have not better way to spend money than to buy back shares and that is your only reason, you need to start a new line or a new business witrh the money. If you have a stock whose price has plunged far beyond the evidence to back up the slide, then a buy back makes a lot of sense. Major buybacks are a way to concentrate ownership also, by the way. Something to think about.

  • Report this Comment On April 30, 2013, at 6:35 PM, shakyhands wrote:

    Since they lowered real interest rates,that has driven demand for equities,so the return on shares has fallen as prices have risen.So if a share is yielding more than treasuries,it is because the market thinks that yield is unsustainable.

  • Report this Comment On April 30, 2013, at 6:44 PM, kavunaru wrote:

    Buy Backs are just to increase EPS. Buy backs will increase when the economy about to slow down because EPS will go down..

    However these companies cannot cook up the revenue. Thatz why we lots of Revenue misses but EPS beat this Qtr.

  • Report this Comment On May 01, 2013, at 7:06 PM, mikecart1 wrote:

    "Shares of Verizon (NYSE: VZ ) now yield less than 4% and Altria Group (NYSE: MO ) , less than 5%."

    This is because both stocks have went up a bunch the past 5 years. MO in particular has over doubled since the infamous March 9, 2009 date. I should know. I invested a ton in it and made mad money like Jim Cramer! :)

  • Report this Comment On May 02, 2013, at 5:43 PM, SkepikI wrote:

    <So if a share is yielding more than treasuries,it is because the market thinks that yield is unsustainable.>

    The key operative word being THINKS. And the market being without a brain, subject to whim and BDM often thinks wrongly, giving some of us delightful opportunities like F, GIS, etc etc. At some point the BDM bids up the price, driving down yields as per @mikecart1, giving us another delightful option to keep getting those yields based on our invested $ OR cash out for a nice gain and move on to the NEXT "unsustainable yield" the market THINKS wrongly about.

  • Report this Comment On May 02, 2013, at 6:52 PM, SD51555 wrote:

    I can't believe any of these companies with a huge run up in the last 6 months would do a buy back. Talk about poor timing.

    The only one that makes sense to me right now is Apple. I can see that one actually adding value.

  • Report this Comment On May 03, 2013, at 2:13 AM, financeMind wrote:

    You forget to mention what is better for top management with stock options and earnings goals for bonuses. Price appreciation is better for their self interests rather than dividends to the shareholders.

  • Report this Comment On May 03, 2013, at 4:28 AM, daveandrae wrote:

    If capital appreciation is truly your goal, I would DE-EMPHASIZE the dividend and focus far more on return on equity. The ratio of operating earnings to total market cap paid. This puts the focus where it belongs, which should always be the purchase price of the entire business.

    For if the entire business is worth buying, then one should be buying as many shares as he can afford, regardless of how high, or how low, the dividend yield is. And if the entire business is not worth buying, then it does not matter how high the dividend yield is. At the end of the day, the entire business is still an unattractive one.

    Put simply, when done correctly, annualized return is a reflection of return on equity. Meaning, if a stock has a dividend yield of, say, 2%, but is yielding 18-20% in terms of its return on equity, then it is STILL a better buy than a good bond that is yielding 12% in interest. For over time, that 18-20% return on total capital must reflect itself in one's total return on principal capital employed.

    Your job as an investor is to know the difference.

    I took this from my investment notes to give one a real world example-


    Over the last twelve months, additional shares of Pfizer stock were purchased at an average market price of 16.18 a share against a present book value of 10.94. (a 1.48 price to book ratio, against a 1.25 ten year average (12.94 p/e) in earnings, equates into a very LARGE margin of safety)

    2010 Operating earnings to total market cap paid (18 / 129) comes in at a very healthy return on equity ratio of 13.95%. Cost basis dividend yield in year one stands at 4.45%, to which one can add 8.15% from capital appreciation, for a total return of 12.60% in year one. The stock closed at a market price of 17.51 a share today."

    total return since 1-1-2011- 82.595%

  • Report this Comment On May 03, 2013, at 5:16 AM, daveandrae wrote:

    Another example of why dividends should be ignored is a hypothetical example.

    Here, one has to make the correct choice between taking 6% off of the top of either David or John's total earnings after ten years.

    David only makes roughly 50,000 a year, yet has 300,000 in savings, earning 18% compounded. John has no savings, but makes 1,000,000 a year and spends it all.

    Which is the better investment?

    6% of 1,000,000 = 60,000 grand.

    Not bad. Unfortunately you could have gotten a lot more from David. For after 10 years, that 300k compounding at 18% is now worth $1,670,800. + 50,000 =

    .06 of 1,720,880 = $103,252.

    Investing in equities is no different. Don't focus on 'earnings per share." Make your focus rather on the return of shareholder equity capital employed.

  • Report this Comment On May 04, 2013, at 8:10 AM, frubeng wrote:

    Hi Morgan,

    Thanks for the article!!

    I would be very interested to find out how you calculated the added yield from the share buyback for the stocks you mention?

    Thanks in advance!


  • Report this Comment On May 04, 2013, at 11:25 AM, SkepikI wrote:

    @daveandrae: Fortunately, capital appreciation is NOT everyone's goal. As one close to retirement, capital appreciation is nice, BUT capital preservation and income is MUCH MORE you will find out, hopefully in a benign way..... Traditionally, Bonds would have filled this role, but with current rate oppression by Fed and price risk, its actually worse for capital preservation and income than very fine dividend stocks like F, GIS, yes and APPL too..

    Secondarily, dividend reinvestment plans make capital accumulation both painless and a bargain, saving transaction costs, which buybacks attract. This works well across bottoms and ok as long as the underlying enterprise stays robust. You might consider those attributes in your analysis.

    Lastly, I've never trusted ROE analysis. I wont even bother with the theoretical why, but over 4 decades, ive seen this analysis screwed up and faked so many times that I don't even bother anymore, except for the odd glance. Its really, really hard to fake a dividend.... As a practical, experimental bit of advice, be wary of ROE.

  • Report this Comment On May 04, 2013, at 2:55 PM, daveandrae wrote:


    Over the last fifteen years I've grown a five figure sum of investment capital at an 18% annualized rate, and I started investing when the s&p 500 was at 1133! Thus, to say you don't trust Return On Equity analysis sounds silly.

    Ignorance is a choice, not an obligation.

    Once again, if capital appreciation is truly your goal, which, Duh, is the very definition of capital "preservation", de-emphasize dividends.

    Based on my experience, a Four Seasons Hotel does not care if your currency came from snow, or if it came from water, it's all MONEY.

    Good Day.

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