The Basics of Dividends

This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

Stop me if you've heard this one. Stocks are stuck in a lost decade. The Dow Jones currently trades at around 11,000. In 2000, it was about the same. A full decade of zero returns. It's a tough statistic to swallow.

But it's equally flawed. Add in dividends, and the Dow has actually increased some 43% over the past 10 years.

Every investor's love for investing can be, or should be, improved by appreciating the power of this chart:

Sources: Yale University, author's calculations.

Albert Einstein called compound interest "the most powerful force in the universe." This chart illustrates why. Dividend investing is powerful stuff that can lead to phenomenal long-term wealth generation.

When a business earns a profit, it can do one of three things: keep the cash in the company to expand operations or repair its balance sheet, repurchase shares, or pay a dividend.

In previous decades, dividends reigned king among those three choices. From 1920 to 1950, the dividend payout ratio (dividends as a percentage of net income) was 72%.

But then began a great shift. Corporate executives got the idea that they could build shareholder wealth more effectively by using retained earnings to build new factories, finance new products, acquire competitors, or repurchase shares. From 1950 to 2010, the average dividend payout ratio fell to 51%. Today, it's less than 30%.  

By and large, this has not been a fortunate trend.

Some companies should have a low dividend payout ratio, if they pay a dividend at all. In the early days of Google (Nasdaq: GOOG), for example, cash was almost certainly better off funding expansion. Berkshire Hathaway (NYSE: BRK-B) has never paid a dividend, but it shouldn't, because Warren Buffett can reinvest money far better than you or I can.

But those are the exceptions. Multiple studies around the world confirm that a lower dividend payout ratio does not lead to higher future earnings. In fact, there's a wealth of evidence showing the opposite: Future earnings growth is fastest when the payout ratio is the highest.

How can that be? Corporate executives, it seems, are poor investors. Cash not paid out as dividends is often squandered on overpriced acquisitions or used to repurchase shares at ill-timed and overvalued prices. Dividends are typically the greatest way management can build wealth for their shareholders.

Consider one amazing statistic: In the 50 years ended in 2003, the single best investment to own was not a tech company like Microsoft. It wasn't an explosive newcomer like Wal-Mart. It was cigarette giant Altria Group (NYSE: MO).

Altria invented nothing new during this period, and, remarkably, smoking rates have been declining for decades. What it did have going for it is an unwavering commitment to its dividend. That dividend, reinvested and compounded over time, pushed total returns to amazing heights. Ditto for other companies that emphasize dividends:

Source: Capital IQ, a division of Standard & Poor's.

Dividend investing is not without risk, of course. Big banks like Citigroup and Bank of America used to pay enormous dividends. Both stocks fell more than 90% as their businesses crumbled. Some note that dividends can provide downside protection during market slumps as investors chase yield, but this is only true as long as the dividend isn't cut, which they often are. High dividends are no substitute for good businesses.

For those interested in dividend investing, keep three things in mind:

1. Track records are important.
Ben Graham, Buffett's early mentor, advised looking for companies with at least a 20-year track record of paying dividends. These are easier to find than you might think. Standard & Poor's keeps an index of what it calls "dividend aristocrats," or companies that have not only paid but increased dividend payments every year for at least a quarter-century. There's no guarantee these businesses will outperform, but it's a great starting point for finding ideas. For more passive investors, funds like the Vanguard Dividend Appreciation ETF effectively track a similar index of high-quality dividend stocks.

2. A high yield can be a warning sign.
A stock with an abnormally high dividend yield can be a sign that investors think its dividend payout is in danger of being cut. A good way to gauge whether a company can maintain its dividend is by checking the ratio of dividends to free cash flow. There are no firm rules, but in general you want dividends to make up no more than 60%-70% of free cash flow. Any higher, and that payout is at a higher risk of being cut.

3. Reinvest!
Some investors use dividends to pay bills or even live off them during retirement. That's great! For all others, a commitment to reinvesting dividend proceeds back into the company is key to generating the greatest long-term returns. Most companies and brokerages allow you to reinvest dividends simply through what's called a dividend reinvestment plan, or DRIP. Once your DRIP is set up, you'll receive dividends automatically in the form of additional shares of that company's stock. Rinse. Repeat. Enjoy.

Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.