Copyright 2006 DVK Group, Inc.
Dividends are transfers of cash by the corporation to its owners—portions of a company’s profits paid out to the company’s shareholders.
Every company has to decide what to do with its earnings. There are three choices.
(1) It can plow them back into the company to fund growth, make acquisitions, or undertake special projects.
(2) It can use them to repurchase its own shares, theoretically making each share still on the market worth more, because it is a larger slice of the pie.
(3) It can siphon off some earnings and return them as dividends to shareholders.
Some companies do all three. All companies do the first, namely retain some earnings for reinvestment into the company. Many companies (but not all) do the second, repurchase shares. And many companies (but not all) do the third: send cash dividends to their shareholders.
Let's focus on the last option, paying dividends (or not). Reasonable minds can differ as to which is better, dividend-payers or non-payers.
Those who think that a dividend-paying company is usually a better company cite factors like these:
• The company must be financially solid; otherwise the Board of Directors would not pay out the money.
• Cash flow must be plentiful. The dividend probably reflects management’s confidence in the stability and growth of future earnings, quite possibly based on information that is not publicly available.
• A company that pays dividends will probably invest the earnings it does retain more carefully. The dividend program imposes discipline upon management, which makes better decisions about what to do with the remaining money.
• Dividends tend to put a “floor” under the price of a stock and to increase the predictability of returns.
In contrast, these are the reasons most often given that companies which are better investment opportunities do not pay dividends:
• Companies on a growth track need all the money they can to make acquisitions and fund good internal projects. Therefore, it is in the long-term interest of shareholders that the company not pay dividends but rather that it reinvest in growth and improvement.
• The payment of dividends suggests that the company does not have enough good reinvestment ideas—i.e., it is a maturing, mature, or stagnating business.
While both sets of arguments make sense, The Sensible Stock Investor finds the first set to be more compelling. That is, the payment of dividends, especially a long history of not only paying but also of increasing dividends, probably points to superior companies with a higher probability of sustaining their earnings growth.
That said, great companies can come in either form. One of the greatest wealth-generators of our time, Warren Buffett’s Berkshire Hathaway, has never paid a dividend. Of course, with Buffett running the show, Berkshire’s executives probably do very few stupid things with the money at their disposal.
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