The Value Of Dividends

“If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained” Warren Buffett

When a company pays a dividend, they are paying you, the owner, with cash that you already own. In theory this transaction shouldn’t create any value. But in practice companies that pay a high and stable dividend tend to get rewarded well by the market.

Numerous academic studies have shown that higher yielding stocks outperform the market over the long run. In his book “The Future for Investors”, Jeremy Siegel studied the performance of the S&P500 constituents from 1957 to 2002. The study showed that the top quintile by dividend yield produced an annualized return of 14.27% versus 11.8% for the S&P500 as a whole.

Why paying dividends is health

If a dividend simply represents a payment of your own money to yourself, why does it appear to make a difference? There are two strong explanations here:

Companies which payout a high dividend tend to be more disciplined. A high dividend enforces a policy of efficient capital allocation – with limited capital to spare, only projects with higher returns get funded and the poor return projects get dropped. These companies adopt a strong sense for the cost of capital throughout all levels of the organization. By contrast companies not paying out a dividend have a tendency to fund all projects, regardless of their return, or worse to engage in value-destroying acquisitions.

A high dividend yield often goes hand in hand with a culture of shareholder friendliness and strong corporate governance. Companies with generous payouts are more likely to treat shareholders fairly when it comes to questions of corporate governance in other areas.

Unfortunately at too many companies there is an obvious conflict of interest between shareholders and management. A bigger company comes with more recognition, greater influence and a bigger paycheck. These management teams like to retain earnings to grow the business (either organically or through acquisition) regardless of the cost to shareholders. A high payout ratio can act as a check on management’s ability to engage in this type of behavior.