Dividends represent nothing more than the investor's share of earnings that will be
received immediately (rather than through reinvestment and future growth of the stock).
Dividends are one of the
quickest and healthiest ways that earnings can make their way into shareholders' pockets.
Graham argued that intelligent investors would
rather have dividends in their pockets (even if investors use them to buy more of the same stock) than
risk waiting for possible future growth. Furthermore, he insisted, it is management's
responsibility to pay dividends.
For long-term investors who follow a
"buy and hold" strategy, dividends are the
only way to collect on investment gains.
In addition to representing money in the bank,
dividends are, to many investors, a
reliable indicator of future growth.
Values are determined roughly by earnings available for dividends. This relation among earnings, dividends and values survives.
A
long history of
dividend payments and regular dividend increases also indicates a
substantial company with
limited risk.
Additionally, a
rise in the dividend is tangible confirmation of the
confidence of management in
good times ahead. A
cut in the dividend is a red flag
indicating trouble on the track.
Not all corporate income need be paid in dividends. Depending on the industry and how much capital is required to keep the business growing, the
appropriate payout may be as much as 80% or as little as 50% of net earnings.
When studying the dividend payout of a company,
calculate both average earnings and average dividends over a 10-year period. From those two averages you can
determine the average payout.
Earnings fluctuate, but
dividends tend to
remain stable or,
in the best companies, to rise gradually.
One way of determining if a stock is
overvalued or undervalued is to
compare its dividend yield with that of similar companies.
- Safety, growth, and other factors being equal, the stock with the highest dividend and the lowest share price is the best bargain.
- As a further check of value, investors should compare the stock's dividend yield with that of the whole stock market dividend yield.
Rationale for Withholding Dividends
If a company isn't paying dividends it should, like Berkshire Hathaway, be doing something profitable with its earnings.
It is acceptable to withhold dividends for the following reasons:
- To strengthen the company's working capital
- To increase productive capacity
- To reduce debt.
Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons. It is easier to keep the cash on hand to bail management out of bad times or bad decisions. Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income. Consequently, other investors get no income.
Dividends in Jeopardy
Dividends may be put in jeopardy in two ways:
- When a company's earnings per share is less than its dividend per share
- When debt is excessive.
A company's average earnings (over several years) should be sufficient to cover its average dividend. Though earnings per share can fall below dividend per share from time to time with
reserves making up the difference, the condition can persist for only so long.
A company with substantial earnings rarely becomes insolvent because of bank loans. But when a company is under pressure, lenders may require a suspension of dividends as a form of financial discipline.
