People in the financial world like to divide investments into opposing categories. Some major divisions, such as stocks versus bonds, reflect the different characteristics that various types of securities have. Others, such as small-cap versus large-cap stocks, or growth versus value stocks, provide more refined information in an attempt to clarify and predict the different ways in which certain stocks behave, depending on their size and maturity.
In evaluating stocks, investors can also separate companies that pay a dividend from those that don't. Although this may seem like a simple difference, many people have strong opinions about dividend-paying stocks, drawing inferences from dividends that significantly affect their investment decisions. Changes in the way companies manage free cash flow, however, have made dividends a more complicated topic than they once were.
The historical role of dividends
For much of the 20th century, many companies paid dividends based on their level of earnings. A study by John Lintner in the 1950s indicated that most corporate managers sought to pay out a certain percentage of their overall earnings as dividends. In general, dividend levels were relatively stable; conservative corporate managers would wait until higher earnings proved to be more than a one-time event before hiking dividends. In this way, investors became used to seeing rising dividends as the primary indicator of a company's success and growth. Also, because stock transactions were more expensive and less flexible than they are now, dividends represented the easiest way for investors to obtain a regular stream of income from their stock holdings.
More recently, however, companies have added other methods of using available cash to enhance shareholder value. Companies often use their cash to repurchase shares of their stock on the open market, which can support share prices and reduce the diluting effects of issuing stock- or option-based compensation to executives and employees. In addition, many newer companies that initially chose not to pay a dividend may see little or no need to begin making dividend payments, even after they become more mature. Huge companies like Cisco Systems
Theory versus reality
On a purely theoretical level, it shouldn't make a big difference whether or not a company pays dividends. If earnings are distributed to investors in the form of dividends, the recipients must choose how to reinvest those payments. Many investors participate in dividend reinvestment programs, which automatically use any dividends they receive to purchase additional shares of stock. On the other hand, if a company retains its earnings instead of paying a dividend, the value of the company should be higher by the amount of cash the company kept. The company can reinvest the money in its business operations or perform capital-structure transactions, such as paying down debt or repurchasing stock.
Indeed, until very recently, there was a significant disadvantage for individual investors holding dividend-paying stocks. Income tax law has traditionally treated dividend payments as ordinary income to investors. However, capital gains have often received preferential treatment, with taxation at lower rates. Therefore, given a choice between receiving a dollar of dividends versus having the stock appreciate by a dollar, tax-averse investors should prefer the stock appreciation.
In reality, however, many investors prefer dividend-paying stocks, and many companies have responded to that preference by continuing to pay substantial dividends. Part of that preference may be simply because dividends represent real money, rather than an abstract paper value. Fluctuations in the stock market may seem arbitrary and baseless, but the certainty of receiving a quarterly check provides a tangible example of the benefits of stock ownership. In addition, changes in tax laws have made the impact of dividend payments on taxes less burdensome. Currently, dividends are taxed at the same rate as capital gains. Furthermore, the rise of tax-deferred accounts, including retirement plans and educational savings vehicles, has made the tax impact of dividends unimportant to many investors.
A recent edition of Dueling Fools debated whether it was better for a company to repurchase its stock or pay dividends. While dividends reflect confidence among corporate managers that a company's earnings will continue to support ongoing payments to investors, buybacks reflect confidence among corporate managers that their company's stock remains a good investment. So far, Foolish community members have resoundingly voted in favor of dividends.
What about performance?
Of course, the $64,000 question is whether dividend-paying stocks outperform their stingier counterparts. Matthew Emmert, who formerly ran The Motley Fool's Income Investor newsletter, is convinced that the answer is yes. In one of his articles, he explained that stocks with high dividend yields have tended to outperform the overall stock market by a substantial margin, often with less volatility in their share prices along the way. He suggests that the "boring" nature of dividend-paying stocks makes them unattractive to many investors, who seek quick, explosive gains with shorter time horizons. When irrational factors make a particular type of investment out of favor, it often creates an opportunity for investors to consider going against the grain.
There's no one correct way to invest. Many dividend-paying stocks will provide strong returns to investors, but many stocks that don't pay dividends will also soar into the stratosphere. Don't expect the debate over whether or not dividends really matter to resolve itself anytime soon. But if you like to see physical evidence of the profits your investments earn, buying dividend-paying stocks is a great way to be confident that your money is truly working for you.
Want to learn more about dividend-paying stocks? See our full Foolish portfolio of dividend dynamos when you try our Motley Fool Income Investor newsletter service free for 30 days.
Fool contributor Dan Caplinger understands financial theory but still likes to see those dividends hit his brokerage account. He doesn't own shares of the companies mentioned in this article. Dell is both a Stock Advisor and an Inside Value pick. The Fool'sdisclosure policyalways pays you dividends.