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BLOG: The power of dividends

BLOG: The power of dividends
Your Money
Written By:
Your Money
Posted:
02/05/2024
Updated:
02/05/2024

A business is worth the cash an owner can get from it, and there are two ways to get that cash: through the mail or through a sale. Collect a dividend payment, or sell the ownership or assets of the company.

Over the lifecycle of a business, investors who might someday sell its stock must guess what others might pay for it.

An early investor might dream of the company’s addressable market, but they must look to the second investor, who may speculate about its sales. The second investor must think of the third, who may predict its path to profits. And that investor must consider the next one, who may estimate earnings or forecast free cash flow.

Free cash flow is an indispensable metric, yet cash does little good if it is stashed or squandered, and if you don’t control the business, you can’t sell it outright, you can’t sell its assets, and you can’t set its payout policy.

But if you owned the whole thing, you could always demand dividends, and it is the perspective of this owner – no matter how hypothetical or far in the future they may be – that determines the intrinsic value of the business.

Dividends tell you something about a business. If it pays out, it is probably profitable, but looking at earnings or cash flow could tell you that. Dividends also tell you that its lenders haven’t pressed to prevent cash from leaving the building, and that its leaders care enough about minority shareholders to reward them.

Historically, looking at dividends as well as free cash flow has often been a rewarding approach. In the US, Europe, and Japan, shares with high dividend yields have outperformed their wider stock markets over the very long term.

Like any lone metric, a company’s dividend is understood best if you deeply understand the business. An exceptionally high yield may presage a dividend cut. This is partly why stocks with pretty high yields have (on average) outperformed those with the very highest yields. High payouts might also tell you that a company can’t find enough attractive projects to invest in, limiting its growth.

Growth is a competing use for cash, and if a company can reinvest in projects with attractive returns on capital, it usually should. Companies can also repurchase their own shares – buybacks have long eclipsed dividends as the preferred way to return cash to shareholders in the US, helped by tax efficiencies.

‘Some buybacks are better than others’

When a company buys its own shares at a deep discount to intrinsic value, buybacks can create enormous value. For companies like the many in Japan trading for less than 1.0 times book value, exchanging one dollar of cash for more than one dollar of book value mechanically boosts book value per share and almost-as-assuredly lifts returns on equity.

For any company, buybacks may make sense if the return on capital already employed looks better than the return on new projects. But companies can also overpay for their own shares, and buybacks provide a tempting way for executives to hit per-share bonus targets or distract from share-based compensation to their colleagues.

‘Dividends are simpler’

They have much to recommend them. They tend to grow more quickly than inflation, which helps to protect real returns. Many companies treat dividends as sacrosanct, so dividends can persist through profit wobbles, and high yields are hard for investors to ignore. A stock trading at 10 times earnings may drop to five times with little fanfare, but if a stock yielding 5% halves in price, its 10% yield will attract lots of curious eyes.

Put those traits together, and shares with high yields can reduce both return and forecast risk. On the return side, high-yielding companies in the US, Japan, and Europe have historically suffered shallower drawdowns and less volatility than wider stock markets. On the forecasting side, dividends are often the most predictable part of a company’s expected return. That is important, as growth forecasts for many years into the future can be off by an inch or a mile.

In markets today, there are plenty of companies with reasonable growth prospects, solid cash generation, low valuations, and high dividend yields.

Assuming you get the dividend yield, a little growth, and a little boost from sensible buybacks, such shares can offer potential returns of 15% per annum. If you can underwrite 15% expected returns with pedestrian assumptions, why bet on predictions for fifteen years in the future?

Rob Perrone is investment counsellor and member of the Orbis multi-assets investment team

Related: The investment trusts raising dividends for half a century