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Do dividends matter?
Mainly income investors should care about dividends

I first saw the title of this article in a university textbook many years ago. It challenged what many investors think intuitively, but it makes perfect sense to those with "Spock-like" logic. This week we'll see why some investors should care about dividends and others shouldn't.

A dividend defined

A dividend paid to holders of a company's shares represents simply a part of the firm's net profits that it chooses to share with its owners - i.e. shareholders. Companies have two basic choices when it comes to deciding on how best to use its net profits. Net profits can be invested in projects they feel will be profitable; or they can distribute some or all of those profits to shareholders so that each investor can decide for him- or her- self how best to invest the money. Generally speaking, unless a firm can generate a certain threshold rate of return on profits they reinvest in the business, they will simply pay out a dividend.

This is why larger, more mature companies tend to have higher yields. Their higher growth days are behind them and feel that they simply don't have enough opportunities to continue investing new money profitably; so they pay a portion of those profits out to shareholders.

In other words, paying out a high dividend is normally done at the expense of future growth potential since less capital is directed toward new investments to fuel future corporate growth.

However, it can also be argued that companies that pay dividends usually have steadier (i.e. less risky) profits - thereby giving management the confidence to pay a dividend.

The economic value of dividends

An investment (be it a stock, bond, mutual fund, etc.) has two ways to generate a return on invested capital. It can either rise in value or it can pay out some type of income or cash flow - or some combination of the two.

The whole idea behind the title of this article is that a rate of return is a rate of return - and the form in which it's realized doesn't matter at the end of the day.

Investor psychology

Behavioural researchers have found that investors would much rather receive a dividend than have to sell some of their shares to generate some cash flow. The reasoning is largely perceptual. Take the simplistic example of two stocks, A and B, and two investors seeking an occasional income supplement, Joe and Jane.

Joe invests $100,000 in stock A at $10 per share (10,000 shares) at the beginning of the year. Jane invests $100,000 in stock B, also at $10 per share (10,000 shares) at the year's outset.

Over the course of the year, stock A paid dividends totalling $0.50 per share, and ended the year with a share price of $10, exactly where Joe bought it. The dividend gave Joe an income of $5,000 for the year ($0.50/share x 10,000 shares) and left him with his original $100,000 ($10/share x 10,000 shares) at the end of the year.

Over the same period, stock B paid no dividends but rose steadily through the year - finishing with a share price of $10.50. At the end of the year, Jane simply sold a total of 476 shares at the ending price to satisfy her $5,000 cash flow needs. That left Jane with 9,524 shares at year's end, which, at $10.50, would leave her with a value of $100,000.

In summary, Joe and Jane each invested $100,000; each received $5,000 in cash flow during the year; and each ended the year with shares valued at $100,000. In other words, the fact that each received their cash flow by different means makes no difference to their investments' worth at year-end.

(I've obviously ignored trading costs to sell shares and taxes on the income. However, the lower tax rate applied to capital gains when selling shares, compared to dividends, for most investors may offset the trading costs incurred in selling shares for income.)

When dividends matter

While the preference for dividends is one based mostly on perception, it's a valid one for those relying on their investments for the bulk of their retirement cash flow. Since high yielding stocks tend to be issued by larger, more mature companies with steadier profits and cash flows; it stands to reason that such firms will be less risky than a company that pays no dividend, has greater growth potential, but less reliable profits.

Hence, dividends do matter but not for everybody and for varying reasons. The greater consistency and generally lower risk should appeal more to income-oriented investors. For investors not desiring income, but rather using dividends to gain insight into the earnings power and consistency of a company's bottom line, it's certainly a useful tool.

The point of the numerical example of Joe and Jane above was merely to illustrate that the form in which a total return is realized doesn't absolutely make, for example, a dividend superior to a capital gain - or vice versa.

Some online references

StingyInvestor is an excellent site for researching North American stocks, including stock screens, including one for dividend yields.

Shakespeare's Investment Primer is a site run by a retired scientist with a passion for investing. There is a ton of useful information on the site, including an essay on the author's methodology for finding his favourite type of stock - one that pays a high and sustainable dividend.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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