Dividend stocks have become popular over the last year, and it's easy to see why.
In bear markets, investors turn to dividend stocks as a source of reliable income and because paying a dividend is generally a marker of reliable profits.
Alphabet (GOOG -0.65%) (GOOGL -0.73%) has never paid a dividend despite being one of the most profitable companies in the world and having $125 billion in cash, cash equivalents, and marketable securities on its balance sheet, but it's a good candidate to pay a dividend.
The company brought in $65 billion in free cash flow in the last four quarters but has struggled to find a way to invest that money to grow the business. Its other bets segment, which includes "moonshot" businesses like the Waymo autonomous vehicle unit and Verily life sciences, have burned billions in cash. Over the last five years, it's reported $20.7 billion in operating losses at other bets on just a fraction of that in revenue, and the losses have generally widened every year.
Even its Google Cloud business significantly trails rivals like Amazon Web Services and Microsoft Azure. In 2021, Google Cloud lost $3.1 billion, though top-line growth in the business remains strong.
Google's core advertising business, meanwhile, continues to grow and drive enormous profits, and that business requires relatively little investment.
As the company's free cash flow has ramped up, it's spent much of that cash on buying back shares.
GOOGL Free Cash Flow data by YCharts.
Why pay a dividend?
Share buybacks and dividends are the two ways companies can return cash to shareholders. Buying back stock helps inflate earnings per share, reducing the number of shares that company profits get divided by, and Alphabet's share buybacks have begun to make a dent in its shares outstanding.
GOOGL Free Cash Flow data by YCharts.
There's nothing wrong with share buybacks, and they should help improve Alphabet's returns over time, but investors generally prefer dividends for several reasons.
First, dividends give investors a reliable income stream and are a way for existing shareholders away to benefit from capital returns. Without a dividend, a shareholder must sell shares to reap the rewards from buybacks or share price appreciation.
Second, a dividend acts as a longer-term commitment to return capital to shareholders. Generally, companies are reluctant to stop paying a dividend once they've started. Share buybacks, on the other hand, tend to fluctuate from quarter to quarter, depending on management's assessment of the capital needs of the business and the share price. However, companies are often bad at timing share buybacks, and Alphabet itself ramped up repurchases as the stock peaked last year.
Finally, paying a dividend would likely give the stock a boost by attracting income investors and dividend-holding ETFs. It would make Alphabet stock attractive to a wider range of investors.
Why now?
In the tech sector, it's often unfashionable to pay dividends. Apple co-founder Steve Jobs famously dismissed the idea of paying a dividend, preferring to keep the cash on hand for bold investments and acquisitions.
Indeed, paying a dividend does, in some ways, signal a company's transition from a growth stock to a more mature business, but that should be a good thing. A mature business generates reliable profits, and Alphabet has long passed that transition point.
Paying a dividend would reward investors and show them that management understands the current reality of the business. At this point, the company is a massive search advertising monopoly with a few money-losing side projects, and it's been that way for years. Paying a dividend would also act as a restraint on its cash-burning projects under the banner of other bets, which could also help the business and the stock.
Finally, it's a great time to initiate a dividend because Alphabet's stock is cheap. It currently trades at a price-to-earnings ratio of 18.5, on par with the S&P 500, and it's even cheaper when you back out its $125 billion in cash.
Alphabet could easily afford a modest yield of 1% or more and have plenty of cash left over for buybacks and investments in other bets.
Though Alphabet may be one of the best-known names in tech, this is also a blue-chip stock now. It's time for it to start acting like one.
