A brief note on dividends

Dividends, dividends, dividends. Even if you're new to the investing world, one of the first things you'll hear about is dividends, the importance of them, or the lack thereof. Investors often fall into two camps: those that seek a moderately high dividend yield (too high is not usually considered good), and those that do not feel dividends add value.

Basically, dividends are payments of cash or stock (usually cash) that a company makes to its shareholders. In essence, if a company earns a profit, it can either re-invest this money in the business, or pay it out to shareholders. Usually, the nature of the company's business and industry will be the main determinant of the size or existence of a dividend. If a company can earn a higher return than its shareholders (r > k), this company will generally not pay out a dividend, or its dividend will be small. This is just common sense. The company can do more with $1 of earnings than the shareholders can. The shareholders, therefore, would rather have the company put that money to work. This type of company is known as a growth company. A prime example would be Google.

If the shareholders can do more with $1 of earnings than the company, then they will seek a high payout ratio. In a perfect world, they would want a 100% payout ratio. Now, this obviously never happens; nevertheless, the point stands. A declining company should seek to return more of its earnings to the shareholders. Now, it's always hard to explicitly identify companies that are said to be declining (because no CEO would ever want to admit that their industry is dying or shrinking). However, take a look at BCE.TO or ROC.TO (Bell - 4.1% yield and Rothman's 5.5% yield), both companies are in semi-declining industries, and their payout ratio is on the higher end of the scale.

"Normal" companies with r = k will generally have an ambiguous policy towards dividend payouts. Many companies would rather try to claim they are a growth firm (note: there is a difference between growth and growing - earnings can be growing, but that doesn't mean it's a growth firm), and they will not pay out a dividend. Other companies will pay out a dividend for several reasons. One main reason is related to clientele theory. Some theorists believe that investors are attracted to a company because of its dividend payout ratio. For instance, some older investors seek current income, and thus, would want to invest in companies that have a high payout ratio. This was a major factor in the rise of income trusts over the last few years, and why so many grumpy old men went ballistic after the governments decision to implement a new tax scheme on the income trusts (more on that in another post to come).

Another key reason why investors prefer companies that pay dividends is that they impose a form of discipline on management. Sometimes, there is a lot of spare cash lying around. If a company doesn't pay out dividends, managers and executives could be tempted to try to put this money to work. This would lead to accepting projects that perhaps have a negative NPV or earn less than the IRR.

Another benefit of dividends is their ability to dampen fluctuations in return. For instance, many REITs have lost a lot of money over the last year. For example, say a stock lost 15% of their value over the past year, this stock however, has successfully paid out a dividend 4 times over the year. This guaranteed return lessens the overall loss on the stock, to say 8%. Furthermore, dividends allow investors to dollar-cost average, by taking the payouts and re-investing them at prices lower than the original purchase price. In the long-run, this can prove to be very enticing, and reinvesting dividends can yield significant returns.

This post has been intended to give a brief overview and introduction to dividends. Clearly, though, it's from a 50,000 foot level. There is a lot more to be discussed, and I suggest reading through your textbooks or taking a look at some sites online. For the purposes of the competition, it might be interesting to take a look at a site like www.thestreet.com, which often has a list of companies that have hiked their dividends. This is usually a very positive sign in the market, and something that investors typically look for. On the flip side, companies that cut their dividends are usually in a lot of trouble. Citigroup, for instance, recently had to cut its dividend in order to free up cash to preserve their capital ratios. So generally, in the short-run, if you see a company cut its dividend, it is usually a sign of bad times ahead in the immediate future. For a foundationally solid company like Citigroup, it could signal something close to a bottom.