Education: Value Investing

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Paying Dividends to Investors

Stocks that are commonly classified as value stocks are said to be currently trading at a discount to their fair value. They usually have relatively low P/E ratios and P/B ratios and have historically outperformed growth stocks (see our article on value performance). Furthermore, they have been paying dividends (literally) to their investors for quite some time.

Excess Cash—What to Do?

A company’s goal is to turn a profit. Once achieved, this particular company must make a decision as to what it will do with its earnings.

Companies that have been around for a short amount of time but are experiencing a great deal of growth typically do not redistribute their excess cash in the form of a dividend to its stockholders. But rather, they prefer to invest their earnings back into their own company, all with the intention of enhancing their growth and fueling their share prices. They figure they can make better use of the cash and this will be in the best long-term interest of their shareholder base. Stocks that fall into this category are typically defined as growth stocks. Think high-flying tech stocks.

On the other hand, once a company reaches a significant size and level of stability and enters the maturation stage, it can begin to consider the declaration of a dividend. With growth stocks going the reinvestment route, value stocks have generally opted to share the wealth. While paying dividends reduces the amount of cash available to the company, the distribution of profits to its owners is, and should be, the goal of any business. Benjamin Graham and David Dodd, in their classic publication Security Analysis, suggest that a company choosing to reinvest its earnings is in effect dictating to its owners how to invest their money.

The Mighty Dividend

Dividends are extremely valuable for a number of reasons:

1. When a bear market is upon us, if you bought a stock that pays a dividend, you are pretty much guaranteed a payout. So, while your stock’s price may be getting hit, your pockets are getting filled up with cash via dividends.

2. An investor’s total return can grow handsomely over the years when a dividend is factored in. Remember that a stock’s total return is made up of both price return, or capital appreciation, and income return. Income return factors in dividends.

3. The longer a company pays out dividends to its stockholders, the more likely it will follow this course of action going forward. Investors have come to expect this additional income, and if terminated, the company runs the risk of upsetting or even losing its shareholder base. Furthermore, a solid, dividend-paying company may increase its yield each year, which would be fantastic news.

Thanks to President George W. Bush, with the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax rate for qualified dividends was lowered to 15% for most individual taxpayers and to 5% for taxpayers whose income places them in either the 10% or 15% tax bracket. This 5% will last through Dec 31, 2007 and drop to 0% in 2008. Prior to the signing of the bill, dividends were taxed at the same rate as ordinary income. These tax benefits are scheduled to expire on Jan 1, 2009; however, Bush signed a two-year extension of the reduced 15% tax rate for capital gains and dividends into law on May 17, 2006.

4. Some companies offer dividend reinvestment plans (DRIPs) to their shareholders. These can be quite beneficial because they allow stockholders to purchase additional shares with dividend proceeds. Little or no commission typically accompanies such transactions and some companies have DRIPs that allow participants to purchase their stock at a discount to its current market price.

Conclusion

Keep in mind that dividends are by no means guaranteed. And as we mentioned earlier, although usually uncommon, they can always be reduced or eliminated altogether. However, I think we have made it pretty clear that companies that pay out dividends are quite advantageous to value investors.