Here's a question I had thrown at me the other day: "Why invest in dividend-paying stocks?"
It was immediately followed by: "I expect a company to reinvest all of its cash for more growth."
This isn't an uncommon line of thought, and it's not a question or statement without merit. There are great companies that should absolutely plow all of their earnings back into their business. For years, American Eagle Outfitters
It's a common perception that dividend-paying companies are mature slow growers. But that's just not always the case. Paying a dividend can be the sign of a responsible management team that sees growth in front of it -- but has more cash than it needs to execute that growth in a controlled fashion. American Eagle Outfitters fits that mold. You could make the argument that Fastenal
All things aren't equal
In theory, a company should plow all of its free cash flow back into the business for additional growth until it reaches the point that it is no longer able to do so. But in the real world, management teams don't always allocate their capital properly. When a company reaches the point that it no longer makes sense to invest all of its earnings into the core business, management might start to reach for growth that is beyond its grasp. If a company chooses not to initiate a dividend, it has a few other options in its quest to reward shareholders. It can make acquisitions in hopes of adding growth (most likely reaching), it can buy back shares, or it can let the excess cash sit in the bank.
The acquisition path is the most daunting. Not only does the company need to pay the right price, but it also needs to absorb, operationally and culturally, the other business. Symantec
Share repurchases can be a great way to return value to shareholders, but the company must be opportunistic and it must understand when its shares are undervalued. Perhaps most importantly, for a share repurchase plan to truly benefit investors, it needs to be greater than the number of options issued. That's no small feat. Dell
Last up is to simply sit on the cash. Great option ... if you're Warren Buffett or have his abilities for allocating capital. Sadly, most of us -- and most of the people running companies that are responsible for investing capital -- do not either. Cash sitting in the bank is better than a bungled acquisition, but neither makes as much sense as a dividend.
Foolish final thoughts
No matter the strategy -- growth, value, income -- the goal of investing is to build wealth and outperform the market. Valuation and growth are paramount, as is the quality of the underlying business. If we can get those three things and receive a 3% or more dividend yield, we're about one-third of the way to a market-beating return without any appreciation in stock price.
This happens to be exactly the formula that Mathew Emmert has put to work in our Motley Fool Income Investor service. A full 70% of Mathew's recommendations are beating the market, including Total S.A.
Interested in learning more about companies that generate robust free cash flow and pay you to hold them? Consider a free 30-day trial to Motley Fool Income Investor. Over the past two-plus years, Income Investor selections have delivered a total average return of 16.2% vs. the S&P 500's 11.7%. There's no obligation to buy if you aren't completely happy.
This article was originally published on Sept. 16, 2005. It has been updated.
Nathan Parmelee owns shares in American Eagle Outfitters but has no financial interest in any of the other companies mentioned. You can view his profile here . Dell is a Motley Fool Stock Advisor recommendation. The Motley Fool has an ironcladdisclosure policy.
