When it comes to stock investing, dividends matter – and don’t. Here is what I mean. Dividends truly matter to overall stock returns and they are not to be ignored. However, when it comes to investing what really matters is how much cash is being generated by the company, not necessarily how much is being paid out to shareholders. So in a way, dividends don’t matter. Dividends are an indicator of how much cash the company is generating, but not the real thing.
First, let’s discuss how dividends matter and are not to be ignored. Dividends are cash payments, typically paid quarterly, to owners of a company’s stock. Dividends sometimes get little attention because they are so small compared to the potential price movements in a stock. For example, over the past 10 years the companies in the S&P 500 have paid out dividends each year equal to about 2.2% of the company’s stock price (this is known as dividend yield). In comparison, a company’s stock price can vary widely, rising and sometimes falling 30% or more in any given year. Most of the popular finance websites only show price changes in their charts and ignore dividends altogether. When there is so much price movement who cares about 2.2% dividends? The answer, of course, is long-term investors. When you average out all of the up and down price swings over the past 10 years, the price of the S&P 500 has risen 5.2% per year. Now the 2.2% in dividends matter, and make up a significant percentage of the overall returns. A long-term investor’s total return over the past 10 years is 7.4%, which is 5.2% in price appreciation plus 2.2% dividend payments.
Here is where we need to caution that dividends are not really what matters. The problem comes from investors who fixate on dividends and ignore what is really happening to the overall company. They treat dividends as some kind of guaranteed return that is the most important part of investing. They reason that if the ‘average’ dividend payout was 2.2% then companies that are paying, 3%, 4%, or even 5% must surely be an even better investment. Unfortunately, this is an overly simplistic view that can get an investor into serious trouble.
What really matters in investing is not how much a company is currently paying in dividends, but how much cash a company is generating, or is expected to generate. While cash dividends and cash generated (or cash flow) are related, they are not the same thing and understanding the difference is critical. While the details can get complex, the fundamentals are fairly straightforward. If a company is generating cash through profitable operations then cash can start to build up within the company. Basically, the company has the option to reinvest the cash to grow even faster, sit on the cash as a reserve, or pay the cash out as a dividend to the shareholder. Here is what is important to remember. As a shareholder, you own a percentage of the cash within the company whether it is paid out to you or not.
Allow me to explain using a popular company that also happens to be the largest component of the S&P 500: Apple. From 1995 to 2012 Apple paid no dividends but became incredibly profitable generating billions of dollars in cash for its shareholders. Since no cash was paid out and since the company continued to increase its profit, cash continued to build within the company and the stock price soared. Cash continued to build within the company until 2012 when investors started to complain and Apple finally started to pay a dividend. Here is an important distinction. Paying the dividend was not an increase in the value to shareholders, merely a payout of the cash that the investors already owned. Meanwhile, investors who shunned Apple from 1995 to 2012 because it didn’t pay a dividend missed out on an incredible return.
There is a common ground in this discussion because companies who pay dividends tend to be companies that also generate significant amounts of cash. It makes sense - you can’t pay cash to shareholders that you don’t have (companies can find ways to pay their dividends even when the company is unraveling, but it doesn’t last long). When we invest, dividends are a factor, but not the only factor in determining whether a company is a worthy investment. Other factors such as cash flow and sales are also critically important. The world is a complex place. While dividends matter, they aren’t the end of the story in investing.
"S&P 500." S&P Dow Jones Indices. 2016. http://us.spindices.com/indices/equity/sp-500.