When you hop onto the NASDAQ or whatever stock tracker you prefer and look at a classic chart of stock price over time, you’re not being told the whole story. If the aim of investing is to earn money, then it’s foolish to forget one of the major ways investors can make money – dividends.
Dividends are regular payouts of a company’s profits made to shareholders, paid per share. They are one of a few ways companies can use profits, other than buying back stock or simply retaining the earnings as assets. While often overlooked by beginning investors, dividends can constitute a significant portion of earnings. For instance, Ford (F) has paid out dividends equaling 5.25% of the share price over the past year, which is at least half as much as an average security’s price can be expected to gain in an average year. Simply put, even if Ford’s stock only gained a seemingly unimpressive 7% in a year, with dividends like that it would still add 12% to the total value of your holdings, a robust return.
There are various arguments for or against using dividends as a criteria for choosing securities. The largest reason in favor is their relative safety – many companies issue dividends on regular schedules and are hesitant to disrupt their schedule simply because of a few bad quarters. This offers a predictable source of returns to shareholders even in bearish markets. Dividends are also often a bellwether for performance – because dividends are issued out of a company’s earnings, a disrupted dividend schedule can signal changes in profitability before they appear on official reports, giving investors advance notice to jump ship or buy more.
Dividend yield is normally measured as a percent of share price, since this indicates the amount that a shareholder’s assets would gain from dividends. Dividends are one of the major reasons that price to earnings (P/E) ratio is important. P/E ratio is simply calculated by dividing the price of a single share of stock by the earnings per share. If a company has a low P/E ratio (under 20), meaning that the amount of profit being produced is high relative to the share price, then this often means that the dividend yield will also likely be high relative to price, giving shareholders greater gains in proportion to the price they paid.
For example, Ford’s low P/E ratio of about 10 is probably why its dividend yield is so high. If Ford’s stock price doubled in value, its P/E ratio would also double from its current value to 20. In the short term, the dividends paid per share (roughly 53 cents per year) would probably stay the same, but as a proportion of stock price they would suddenly be cut in half.
Some economists argue that dividends are theoretically irrelevant. If an individual investor is paid more than they expect in dividends, they can simply use the dividends to buy more stock; if they don’t receive enough in dividends, they can sell shares to receive cash instead. Additionally, the alternative use of earnings, stock buybacks, theoretically increase shareholder value by an equivalent amount, since decreasing the number of shares in circulation proportionally increases the value of each share according to the simple laws of supply and demand.
However, such a model makes simplifying assumptions which are simply untrue. First, it assumes that stocks are infinitely divisible, but obviously they must be purchased as whole assets. Especially for small investors who may own only a few shares of a stock, dividend yields may not be anywhere near enough to buy another share. Also, dividends often follow different taxation rules from share price gains, typically being taxed at a lower rate, so they might represent a more lucrative way to get in on a company’s gains.
Because dividends are so closely tied to fundamentals and earnings, both of which are primary consideration for us here at Dynalect when choosing stocks, we engage in some degree of dividend investing. Certainly, for beginning investors, they can represent a quicker and more secure way to start seeing returns.
Until next time,