There is More to a Dividend Paying Stock than Just a Check in the Mail
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Just as Pablo Picasso said that, "Every portrait is a self portrait," investors can tell a great deal about a company from its dividend paying policy.
For years, high tech companies such as Microsoft (NASDAQ: MSFT), Oracle and Intel (NASDAQ: INTC) did not even pay dividends. Management at these firms felt that the cash was better utilized for research and development purposes or buying other companies with promising product lines than rewarding shareholders with the proverbial "check in the mail." Based on the stock price performance over the last decade for Oracle, Intel and Microsoft, shareholders were treated very poorly as result of this board policy.
The critical role of the dividend in the total return of an equity is hardly a recent development, however. In his book, Enough, legendary investor John Neff, founder of the Vanguard fund family and creator of the first index fund, points out that the income feature of a stock has provided over 40% of the total return. For decades such as the last when the total return is flat or even negative, and likely many periods ahead, income from a dividend paying stock provides the only positive return.
Just the existence of a dividend is also a useful due diligence feature. Jesper Madigan, manager of several Asian income funds for the Mathews group, pointed out in an interview with the American Association of Individual Investors, "Investing in Asia for Dividend Income," that of the more than twenty publicly traded Chinese companies revealed to be fraudulent, not a single one paid a dividend.
For a dividend paying stock, the size and the payout ratio are also very telling. At present, the average dividend yield for a stock on the Standard & Poor's 500 Index is around 2%. The historic payout ratio, the amount of earnings dedicated to paying the dividend, is about 50% for a Standard & Poor's 500 member company.
Investors should look for a robust dividend supported by a healthy payout ratio. A dividend that is too high with an irresponsible payout ratio should be avoided as that company has a bleak long term outlook. A dividend policy such as that reveals the board is trying to attract investors with the income stream, not future growth. As important as a dividend is, capital is still needed to fund expanded operations and higher profits for the company.
Medigan also pointed that a payout ratio of around 40% is a manifestation of prudent financial management with a respect for the rights of minority shareholders. A payout ratio of this degree also indicates to investors that there is plenty of cash flow to finance increases in the dividend for the future or to initiate share buyback programs.
As Dirty Harry in the movie "Magnum Force," Clint Eastwood once remarked that a man must know his own limitations. The performance of stock repurchase programs do not evince this sage advice about life from San Francisco Police Inspector Harry Callahan. In an article on share buyback programs in The New York Times by Robert Cryan and Christophe Hugers, "A Bad Record on Buybacks," it was noted that, overall, "American companies have a terrible track record of buying their own shares high and selling them low." The performance in mergers and acquisitions is just as abysmal, particularly in the high tech sector.
Microsoft writing off its $6.2 billion buy of aQuantive is a timely example of why shareholders are better treated with higher dividend income than more corporate transactions.
This is now evinced by the healthy dividend yields of Microsoft, Intel and Apple (NASDAQ: AAPL). Microsoft now has a dividend yield of 2.6%. The dividend income stream provided from Intel is now at a 3.13% rate. Apple pays a dividend of 2.65%. Each of these companies has a payout ratio well below the historic corporate average which leaves plenty of cash flow for dividend growth in the future.
The payment of a dividend represents the commitment of a company to its shareholders to share the wealth. The size of the dividend and the payout ratio tell a great deal about the soundness and stability of the financial management of the company. Even more important for shareholders over the last decade, and quite possibly for some time in the future, dividends will represent the only positive feature of the total return for equities.
jonathanyates13 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Intel, and Microsoft. Motley Fool newsletter services recommend Apple, Intel, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.