Dividend stocks according to some experts provide a cushion against a market downturn. Why would we invest in companies paying no dividend? Read the article to know why!
A dividend is a payment made by a company to its stockholders’ bank accounts. This payment can be done once a year, once a quarter or even once a month. Many investors like dividends because they provide them with spare cash that can be invested in new companies. Dividends are an alternative way of returning capital to shareholders to share buybacks.
A dividend is paid from the profits that a company is making. A key metric is the payout ratio, meaning the percentage of company earnings that are paid out in dividends. A high payout ratio means that the dividend might get cut if the profits are under pressure. Lower payout ratio means the dividend is on a more solid footing.
Another key concept is the dividend yield. This is calculated by taking the dividend paid per share and dividing it by the share price. Average dividend yields of common large cap indices land typically around 2%. Typically investors see higher yields as better than lower yields.
Why companies pay dividends? What are dividend stocks?
The short answer is that the company sees dividend payouts as the most efficient use of capital available. If there are no growth initiatives, no debt to repay and no other reasonable ways to consume the excess capital, the company can pay out the money as dividends. This is seen as the best way to create returns to shareholders of the company stock.
Many companies that have profiled as “dividend stocks” are proud of their tradition of paying out established dividends. Many shareholders rely on the company to pay out its regular dividends and the dividends can be the sole reason for certain investors to own a stock. The high-dividend players are usually more established, less growthy names.
What can a company spend its money on?
- Costs of goods sold; all expenses related to producing, marketing and selling. Personnel costs.
- General & administrative costs; can be rents, insurance and subscriptions. Also includes management compensation and expenses for certain departments such as legal
- Paying Taxes
Above are some examples of the things that a company typically needs to fork out money for. For a company that will, after these expenses, have money left, they can choose whether to retain (save) it or pay it out to shareholders.
What logic does a company use when deciding how to allocate capital?
When a company makes a decision of how to use its money it will consider which alternative will yield the highest result.
For example, if company X has a after-tax result of 1.000.000 USD, it can use this to either invest in growth initiatives or pay it out to owners. If we say that a potential initiative costing 1 million will provide a return of 20% this would mean the company would next year be earning 200.000 more than the year before. This takes total earnings to 1.200.000.
If instead the company would decide to pay out the whole sum for its shareholders, the paid out sum would have a yield that could be calculated as follows.
Let’s assume a P/E of 15. Then our company has a market cap of 15.000.000. For this market cap, a payout of 1.000.000 means a yield of 6.7%.
Whereas if the company decided to choose the growth initiative, it would increase it’s earnings by 20%. This would cause the P/E ratio to become 12.5. If we assume the market will reward our company with a stable P/E of 15, this would lead to the market value increasing to 18.000.000. This would represent a return of 20%.
In our example, by investing in the growth initiative and by paying no dividend, our company can return 20% instead of 6.7%. This illustrates that dividend payouts always have an alternative cost. If the management is capable they will make the decisions that are the best for the shareholders. However, this is not always the case.
Investing in dividend stocks vs stocks paying no dividend
Pros of dividend stocks:
- provide investor with cash during market downturn, allowing them to take advantage of lower prices
- payments can complement income
- dividend payouts can grow which means the yield will slowly go up without the investor having to do anything
- dividends can indicate management being owner-friendly as they return capital for investors
- stable dividends indicate good financial health of a company
Pros of stocks not paying dividends:
- companies can invest the saved money into growth initiatives or acquisitions with potential for higher earnings and thus higher share price
- typically younger or growing companies pay no dividend and this means there’s more growth potential
- no established need to pay out dividends makes these companies more adaptable to new financial conditions
What to buy, dividend stocks or not?
Deciding on which stocks to buy will depend on the fundamental quality of the business and the price paid for it. If you find a great company for a great price it probably doesn’t make a big difference whether it pays a dividend or not.
However, personal preference plays a role here. Some investors love the perceived stable flow of dividends to their bank accounts. Others prefer younger, faster growing companies investing in themselves instead of paying out dividends. There are also companies that are doing both.
Our opinion is that a dividend is a nice addition if the company has a low payout ratio and still keeps investing in itself. We prefer not to buy companies with high payout ratios or high debt levels. These can indicate a problem in the fundamental quality of the business or a management that’s lacking in competence.
Buying companies that have low debt, above average return on capital, high profit margins and great track records is our preferred strategy. If these companies also pay a dividend we’re happy to receive it but this isn’t a factor we typically consider. We buy stocks for the long term and plan on holding them for at least 5 years.