A Dividend Facade

Dividend paying stocks are an interesting investment to consider. Many investors believe that they are an easy score. Why not invest in a company that will pay a dividend right? I mean, it sounds like a great idea. On the surface it seems like you’re getting some money regardless what the company is doing in their business activities, and in times when government interest rates are low (below dividend rates), a dividend yield definitely seems more attractive than a fixed income investment. Boy can this ever be misleading.

Firstly, as value investors we must remember that a great dividend payment doesn’t mean that we are looking at a great investment. We invest in companies as though we are to purchase the whole company and make it ours, not as though we are just purchasing a few shares. Therefore we must look at the economics of their business and their growth potential. A perfect example of this is General Motors. Prior to 2008 they were paying a dividend, which would imply that they are making enough money to cover their own expenses and have additional cash to pay out to shareholders as a reward. But there was a flaw in their business as they ended up filing for bankruptcy in 2009 – something that a dividend would have implied the opposite of.

While very happy to receive dividends, investors must also look at the payment history of dividends from a company. For a company to issue dividends, it must have a reasonably concrete perspective on the future of their firm. Reducing dividends once they have been issued is a major negative indicator – the company must hold back funds to cover their own needs prior to paying shareholders. However, maybe they are holding back dividends in order to use the cash to make a major strategic corporate move in order to further the company’s future growth. We have to be prudent and learn why they are doing what they are doing.

So, dividends can’t really tell us much about the value of an underlying company; let’s look at the dividend yield ratio. This is the annual dividend divided by the current stock price. The inverse of this ratio is the implied earnings yield multiple. So for example, if a company pays out a dividend yield of 2% this means that the implied earnings yield multiple is 50x. So an investor would be paying 50x the price of the company based on earnings. This is quite high, especially if you’re analyzing a company that may not have any growth potential. It’s over valued and will adjust to its intrinsic value at some point. This is a steep price to pay for a few extra bucks in dividends.

In contrast, a company could be withholding their cash from paying out dividends because they have a significant amount of growth opportunities. This was the case with Apple, the most valuable company at one point. They held back all of the cash reserves, which frustrated shareholders, so that they could put it forward into developing new technologies that became monumental to the tech industry. They eventually ended up paying out special dividends in order to quench the thirst of shareholders. But, know that they were special dividends and one time only.

The conservative nature of value investors must focus around the intrinsic value of an underlying company and buying it well below that. Income is great but not the primary concern.