The Dividend Dilemma

The following article is based on a chapter from Aswath Damodaran's book Investment Fables.

Companies that pay dividends reward investors with both income and potential stock appreciation over time. The dividends received from stocks are usually less than the coupon payments from bonds, but the potential price appreciation is much greater with stocks, thus setting up the classic trade-off between fixed-income and equity investments.

But what if you could capture the best of both worlds -- high-yield income with the appreciation?

This seemingly anomalous idea is one of the cornerstones of the high-dividend investment strategy. Some companies pay such high dividends that their yield matches or exceeds that of a risk-free bond. Here's a list of some larger companies whose trailing dividend yields exceed that of the current U.S. Treasury bond rate.

Source: Yahoo! Finance. As of Aug. 5, 2009.

By holding these stocks, an investor can make more than by investing in bonds, without the stock ever appreciating. Any appreciation in the stock is considered an added bonus.

Another reason why the high-dividend investment strategy is appealing is that many of the companies that pay high dividends are larger and established, making them less risky.

During a recession or bear market, investors typically flock to these stable securities, because the income received from dividends can offset or alleviate some of the value lost in the stock price.

Why you should go with dividends
So do dividend-paying stocks really make better investments than their non-dividend-paying counterparts? Well, like anything in this world, there are various schools of thought on this matter.

Some investors believe it is better to invest in non-dividend-paying stocks, because the earnings can be reinvested into the company to generate growth. Earnings that are paid out in dividends are taxed twice, once at the corporate level and again for the investor. Reinvested earnings are only taxed at the corporate level, allowing more cash to generate higher compounded returns.

Other investors argue that dividend-paying companies are superior investments because the payouts show that management is commitment to its shareholders. Paying dividends takes cash out of the hands of management -- which can't always be trusted to make decisions with the shareholders' best interests in mind -- and gives it directly to investors.

Is the dividend sustainable?
For those who see this income as a benefit, there are two important things to keep in mind. First, investors must understand how much a company can "afford" to pay in dividends. If a company is paying out unsustainable dividends, it's only a matter of time before the dividend will be cut. This is one of the risks of investing in high-dividend equities instead of bonds. People who invest in bonds are guaranteed a coupon payment until the bond matures. In contrast, equity investors have no such guarantee on their dividends, as companies have the freedom to cut or cancel their dividend payments at any time.

To reduce their risk, investors must calculate the company's free cash flow to ensure that it exceeds the amount being paid out in dividends. Free cash flow, unlike net earnings, tries to measure the amount of cash a company has left over after all of its reinvestment needs have been met. When a company's dividend payout exceeds its free cash flow, it is not only reducing its asset base, but it may not be reinvesting enough to sustain itself. Over an extended period of time, this can increase investors' risk.

Can a dividend-paying company still grow?
The second thing to keep in mind is a company's long-term sustainable growth rate. A company grows based on how much it reinvests and the quality of its investments. Companies that pay out dividends have less capital to reinvest; therefore, their long-term sustainable growth rate is expected to be less than the return on equity. As the payout ratio increases, the chance for price appreciation decreases, along with the diminishing expected growth rate:

Expected Long-Term Sustainable Growth Rate = (1 - Payout Ratio) * (Return on Equity)

As an example, let's assume that a company pays out 60% of its earnings in dividends and currently generates a 12% return on equity. Assuming this trend continues, the expected long-term sustainable growth rate would be (1 - 0.60) multiplied by 0.12 = 4.8%.

Investors seeking both price appreciation and dividends need to make sure that the company can still grow earnings. It is unreasonable to assume that companies with large dividend payouts can grow at double-digit rates, but companies that aren't even keeping up with overall long-term economic growth rates have very little chance for price appreciation.

In summary, companies that pay dividends seem to offer the unbeatable combination of income and price appreciation. The risk of this investment strategy lies in each company's ability to pay its dividend while continuing to grow earnings. Therefore, investors should look beyond the investment yield, considering a company's payout ratio and expected growth rate as well.

For more on the power of dividends:

• These Dividend Stocks Have It All
• The Next 3 Dividend Dynamos
• You Should Buy Stocks Just Like This One

Start investing today -- just $7 per trade with Scottrade. Or find the broker that's right for you.