• Strategy
  • CFO Magazine

Learning to Love Dividends

Why an old-fashioned financial tool is worth a second look.

This is the age of the share buyback. With record amounts of cash swelling corporate bank accounts, companies are increasingly giving money back to shareholders by buying their own stock. Over the past year and a half, companies in the S&P 500 have spent a staggering $515 billion repurchasing their own shares.

Dividends aren’t nearly as popular. While companies are paying more of them these days — at least partly because of the 2003 tax cuts on capital gains and qualified dividends — the ratio of dividends to earnings is close to its lowest level since the late 19th century.

It’s no secret why buybacks dominate. They are tax-deferred, while dividends are still subject to a 15 percent tax. They are also one-off: repurchasing $50 worth of stock today doesn’t create an expectation that you’ll do the same next quarter. Cancel a dividend, however, and you are alerting the market (and your competitors) to a cash-flow problem. Finally, many people assume buybacks to be a better way of boosting the stock price, since reducing shares outstanding raises earnings per share.

But companies may be underestimating the humble dividend. Demographics and market conditions are creating a large group of investors that will increasingly demand income-producing stocks. Furthermore, there is new evidence that for companies able to make the commitment, dividends may provide a bigger boost to share price than buybacks.

Not Just for Widows and Orphans

During the boom years of the 1980s and ’90s, most investors greeted dividend announcements with a yawn. What was the point of a dividend yield in the low single digits when share prices were rising so sharply? Now, investor attitudes are starting to turn. Asset prices are only creeping up, and few analysts expect that to change any time soon.

“In this market, the dividend makes a great difference to overall returns,” says Greg Church, chief investment officer of Yardley, Pennsylvania-based Church Capital Management, which manages $2 billion in assets. “If capital appreciation is in the 7 to 8 percent range, a 3 percent yield gets you into double digits.”

Over time, that additional yield can add up. Since 1926, dividends have accounted for 41.1 percent of the total return of the S&P 500, according to Standard & Poor’s. Furthermore, the return from dividend-paying stocks is less volatile, thanks to the steady flow of income. All of these features make dividend-paying stocks more alluring — particularly to the hordes of baby boomers on the verge of retirement. And the boomers are starting to make their wishes known. “We’re starting to see enormous pressure from individuals and some institutions for dividends,” says Howard Silverblatt, senior index analyst with Standard & Poor’s.

One sign of this is the willingness of investors to applaud dividend payments by companies that would have been unlikely candidates just a few years ago. For example, when Pegasystems Inc., a Cambridge, Massachusetts-based software maker, announced its first-ever dividend in June, its share price traded up 5 percent on the day of the announcement. “We were a little worried,” admits interim CFO Shawn Hoyt. “We’re a small tech company. Would investors think that this contradicts our growth story? As it turned out, the reactions were positive or, at worst, neutral.”

Discuss

Your email address will not be published. Required fields are marked *