What good are dividends?
Public Domain. Source: PD Photo
It’s a good question. Dividends can limit a company’s options, forcing them to cough up cash that could be used to run the business. If they money flows out of the company, they might have to increase their borrowings. Ford paid a big special dividend in 2000—they called it their “Value Enhancement Plan.” Management probably wished they still had that cash a few years later during the financial crisis.
You’d expect that paying dividends would make those companies more risky. But in fact, the opposite is the case. It turns out that the stocks of dividend-payers are less volatile than non-dividend payers. Why?
Part of the reason is the accountability. When a company pays a dividend, they have to come up with cash every quarter. This keeps them from doing anything too foolish. Investment bankers can cook up some awfully creative structures. Dividends require a certain amount of management discipline. Second, dividends are totally transparent. You’ll never hear about an accounting scandal where dividends were misstated. Earnings, cash flow, and even revenues can be fudged, but if a company says it’s paying a 50-cent dividend, there better be a check for 50 cents per share in the mail.
Finally, dividends are an admission by management that the shareholders—not the managers—own the company. If a company generates free cash flow—the cash from operations that remains after capital expenditures—it can do three things with the money that directly benefit investors: pay down debt, buy back shares, or pay dividends. Because boards are reluctant to cut them, dividends represent a concrete statement of faith—by those in a position to know—in the company’s stability and potential for growth.
Photo: Emmanuel Douzery. Source: Wikipedia
It’s easy to get distracted by PE ratios, Sharpe ratios, cash flow yield, and other metrics. These are important, but we should never forget that a stock represents a real company making real business decisions. When companies decide to give consideration to their shareholders, that’s always a good thing. After all: ultimately, it’s our money.
Douglas R. Tengdin, CFA
Chief Investment Officer