More Proof That Companies Shun Dividends at Their Own Peril

Some investment rules are so powerful they can't be rebutted with a straight face. That companies with higher dividends tend to outperform those with lower dividends is one of them. One thousand dollars invested in the S&P 500 in 1957 was worth $176,000 in 2006. The same $1,000 invested in the top 10 S&P companies with the highest dividend yields was worth $1.3 million. Countless academic studies show that dividends are typically the best way companies can reward shareholders. None that I know of argue the opposite.

But you'd never know this by looking at the behavior of corporations. For half a century, they've been distancing themselves from dividends with a passion. The dividend payout ratio -- the percentage of earnings companies pay out as dividends -- for the S&P 500 is now at the lowest level in recorded history, less than half its historic average. Since 1990, S&P 500 earnings have grown more than fivefold, yet dividends have merely doubled.

There are all kinds of reasons companies might be shunning dividends. Management often thinks it can use earnings more efficiently on acquisitions (few can), or put it to better use on share buybacks (rarely works).

Another popular explanation is that more CEOs are being compensated with stock options, which lose value when a dividend is paid. By not paying a dividend, cash stays inside the company, increasing the net worth of the business and raising its stock price and the value of a CEO's stock options. CEOs are incentivized to avoid dividends, some say. They want shareholder returns to come from rising stock prices, not dividends, even if it means a smaller total return.

The theory makes sense, and could explain part of why dividends have declined so dramatically. CEOs are just doing what they're incentivized to do. But if avoiding dividends in the name of a higher stock price is their intention, there's evidence that it's backfiring.                        

I took the 500 companies in the S&P 500 and ranked them by dividend payout ratio, and then looked at the average P/E ratio of each quintile. What it shows might surprise you. Companies that pay the most dividends tend to have higher P/E ratios:

Source: S&P Capital IQ, author's calculations.

Now, the group that pays no dividends (129 companies in the S&P 500) actually has a pretty high P/E ratio. This makes sense. A select group of companies are very good at investing in themselves and create a lot of value without paying dividends. The group includes some of the highest-quality, best-run companies in the world, names like Amazon (Nasdaq: AMZN), Chipotle Mexican Grill (NYSE: CMG), and Berkshire Hathaway (NYSE: BRK-B). These companies shouldn't pay dividends because they can invest money more efficiently than most of their shareholders, and the market knows it.

But they are the exception. For the majority of companies, there's a clear trend: pay higher dividends, and the market will reward you with a higher P/E ratio.

Some examples of this are almost comical. Consolidated Edison (NYSE: ED) is a slow-growing utility and has a P/E ratio of almost 17. Microsoft (Nasdaq: MSFT) is growing briskly and has a P/E ratio of less than 10. AT&T trades at about the same P/E ratio as Apple, even though Apple's growth potential is unquestionably greater.

How can this be? The best explanation is that Edison and AT&T pay out most of their earnings as dividends, while Microsoft and Apple offer low or no payouts. Investors still pay up for earnings and growth, but they'll trip over themselves for dividends. Starving for yield with bonds returning close to nothing, this isn't surprising. Even if interest rates were at normal levels, companies that pay low dividends should be discounted relative to high-paying companies, since there's such a widespread and consistent history of management squandering cash while attempting to "grow" their business.

These numbers should also add a twist to the idea that CEOs are avoiding dividends in order to increase the value of their stock options. That might be their intention. But the opposite, it seems, is actually happening. Most companies could increase their stock price -- and hence the value of executives' stock options -- by paying higher dividends.

Most, however, won't. CEOs will keep deluding themselves into thinking they have the Midas touch in deal-making or have a knack for stock buybacks. The irony is that coming to terms with the fact that they don't wouldn't just help outside shareholders -- it'd help their own paychecks.

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