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By babyfrog
October 22, 2002

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Note: This post contains hypothetical examples. The future is not guaranteed; investors can and do lose money. The stock market has risk. No representation is made that any investor can or will replicate the performance illustrated in this post.

A dividend is about far more than the cash flow, itself.
Remember, a share of stock represents a fractional ownership stake in a company. As owners, those "earnings" really belong to the shareholders. If management doesn't like that fact, then management can take a company private and do with it what it likes.

A dividend is the method by which owners' earnings are transferred from the company to the owners. Companies that pay and grow their dividends in proportion with their earnings better acknowledge the fact that the CEO may run the company, but the CEO really does work on behalf of the shareholders.

Consider the following:
1) By the Dividend Growth Model of investing, the only factors that matter in the price of a company are the dividends, the expected dividend growth rate, and the total return needed by an investor to compensate for the risk of being invested in the company (as opposed to any other investment. As such, determining a fair price for a company becomes easier if that company has a history of paying and growing its dividends.

2) It's hard to fake dividends (part 1). In order to pay out dividends, a company needs cash on hand and retained earnings. If a company constantly has to borrow money to pay its dividends, then that borrowing becomes evident pretty quickly, putting into question the company's accounting.

3) It's hard to fake dividends (part 2). If a company claims extremely rapidly growing earnings, but doesn't adjust its dividends appropriately, that's a signal to investors that the earnings may not be as clean as they originally appear.

4) A bird in the hand is worth two in the bush. Face it, if a company goes bankrupt, shareholders lose all the future value and 'enterprise value' in the company. They would, however, keep the dividends that they have already received. Complaining about a $0.10 a share dividend being 'worthless'? Compare that to a company whose fraud is exposed, whose business turns sour, or whose products incur liability costs that force the firm into bankruptcy. How much is that whole company 'worth' to the shareholders? $0.00

5) Dividends, if reinvested, compound quickly. A stock with a 2% dividend yield that grows its dividend by 8% a year (not difficult if the underlying company is growing Earnings per Share 8% a year) will provide around 10% compound annual 'income' growth rate to the shareholders who reinvest. Not to mention, if you hold the company's yield constant, an increasing dividend helps promote an underlying capital gain, as well. I don't know about you, but my salary isn't growing at 10% a year. Sure, $50,000 invested today (at those numbers) only provides $1,000 in income, but compounded (tax deferred) over thirty years, that's about $17,449 in income, annually (on a stock investment that has grown to about $872,470). Without adding another dime! Now imagine that in the context of a 401(k) and/or IRA, where you can add to that money over the course of an entire career.

6) On a large enough base, dividends can provide inflation-protected income. Take the same example, above, and consider it with not a one-time investment, but a series of periodic investments across a lifetime. Now, after the 30 years of compounding, instead of reinvesting the dividends, take the dividends out of the account and live off of them. The dividends (should) continue to grow the 8% a year, which (should) allow an investor to live off the dividend income alone, without touching the principle at all.

7) Dividends are hedges against stock dilution. If a company has 1 billion shares and is paying a $0.10 per share dividend, then that company has to come up with $100,000,000 in cash. To maintain that dividend in the face of options grants or stock-funded purchases that increase the company's float to 2 billion shares, the company needs to come up with $200,000,000. As such, it becomes a lot harder to dilute the value of the existing shareholders' shares with dividend paying stocks, because the dilution results in additional money the company has to pay out to maintain its dividends.

8) Dividends are extremely strong signaling devices. Remember, dividends are not guaranteed payments. As such, when times get tough or management is expecting things to go less well than they are publicly claiming, they may feel pressure to reduce the dividend, maintain it as static even when they're publicly forecasting earnings growth, or rise it less quickly than earnings are rising. Alternatively, if management does raise its dividends, in line with earnings growth estimates, then it is a very clear signal that the management really believes they can make those targets.

9) Remember, the shareholders are the owners of the company. It is the shareholders' capital that is at risk. In the event of a default or bankruptcy, the shareholders are last in line and typically walk away with nothing. As such, the shareholders deserve to be compensated for their financial risk in a profitable enterprise. The most direct form that compensation can take is in the form of a dividend.

10) Dividend paying stocks tend to drop less when the market is down. All stocks have a minimum value that they can drop to; that value is $0.00. (Hence the term 'limited risk'. Investors' risk is 'limited' to every penny they invest, and not a penny more.) However, all other things being equal, a dividend paying stock whose dividends are well covered has a dividend-cushioned floor somewhere above $0.00. If the company is paying out a well-covered $1.00 annual dividend, what is the likelihood (in today's low-interest-rate environment) of that company's stock dropping below $10 a share? At $10 a share, that yield is 10%! Yet a company that pays no dividends has no such cushion.

11) Dividends are better than salary. People have to work to earn their salaries. To 'earn' dividends, all they need to do is buy stock in a company that pays dividends, and let other people (the company's executives, managers, and employees) do the work for them. Additionally, from a tax perspective, employees (and their employers) have to pay social security and Medicare taxes on salaries. Those taxes are not levied on dividend income. So off the top and automatically, people are better off with $1 in dividend income than $1 in salary income.

12) Dividends are more predictable that capital gains. While dividends are not guaranteed, neither are capital gains. Yet management that properly understands the value of dividends will not lower those dividends unless it becomes absolutely necessary. (Note: I am a P&G employee and shareholder, and the following example uses P&G as an illustration.) For example, in March 2000, Procter & Gamble's (P&G) stock fell by about 50% in a couple of days. Investors in P&G who were in need of money and were looking to sell stock to get that money, all of a sudden discovered that they would have to sell twice as much stock to get the same amount of money. Yet investors who were looking for P&G's dividend did not lose one thin dime, the company maintained its dividend payments. In fact, since then, P&G has raised its quarterly dividends from $0.32 a share to $0.41 a share, an increase of 28% in just over two and a half years. The stock -still- has not recovered to its valuation levels from early 2000, but dividend seeking investors have seen they're payments rise quite a lot. (more information)

Dividends are extremely powerful and important parts of well-managed, profitable companies. Not just for the immediate cash that they provide. That amount may very well be trivial. Dividends are important because of what they truly represent to the owners of the company that pays them.

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