It used to be that when it came to dividends, investors could literally count on the check being in the mail.
Dividends were traditionally the way companies distributed excess earnings to shareholders. They represented an investor's slice of the corporate pie. Even when investors couldn't count on their stock appreciating, they could bank on their dividend income.
Yet the time-honored practice of paying dividends appears to have lost some of its luster over the past two decades. Once the apple in the corporate pie, the dividend has become more like the mincemeat of fillings: People have heard about it, but they rarely taste it.
Companies should reverse this trend and restore the practice of paying dividends as a matter of principle. Shareholders own the company; the earnings are theirs, so companies should give them back.
The good old days: Shared earnings
Until the mid-1990s, dividends were used by most American corporations of any size to return value to shareholders. From 1926 to the present, dividends represented, on average, 40 percent of the total return of the stocks in the S&P 500 Index.
Moreover, it used to be that a company's dividend policy said something about the company. Raising the dividend reflected optimism about a company's earnings prospects. Lowering it usually was a harbinger of tough times. Suspending or eliminating it was a bad omen.
For companies whose shareholders number into the thousands, dividends are the most direct way to interact with their owners.
Dividends also impose a measure of accountability on managers who may not directly own a big enough stake to cause them to act in the best interests of the company, rather than their own.
The dividend disappears
But today, fewer companies are sharing the earnings pie with shareholders. And when they do, the slices are considerably thinner than they once were. Payout ratios – the percentage of earnings returned to shareholders – are at all-time lows.
In 1980, at a time when companies typically paid out more than half their earnings in dividends, 94 percent of the companies making up the S&P 500 Index paid dividends. Today, 75 percent, or 373 companies, do.
It used to be that a blue-chip stock was a large stock with not only substantial revenues, earnings, and cash flow, but also a big dividend, and usually a big dividend yield. Since the 1920s, US stocks have returned, on average, 10.4 percent a year, with 40 percent of that generated by dividends. And that includes the last seven or eight years of record-low dividend payouts. But nowadays even a blue chip doesn't conjure the image of dividend payout.
In 1985, investors in blue-chip stocks could expect a nice dividend yield on top of potential capital appreciation, or increase in share price. The companies that make up the S&P 500 Index were yielding an average of around 3.5 percent, and the top 15 stocks were yielding 4.5 percent.
Today, the S&P 500 Index is yielding just 1.8 percent (as of June 30, 2007), and the companies making up the index are expected to return just 30 percent of their earnings in dividends in 2007 – a record low.
The average yield of the 30 stocks in the Dow Jones Industrial Average is just 2.1 percent, slightly higher than the broader S&P 500 Index, but well below historical payouts.
Companies help themselves
It is true that US companies have raised payout rates at a double-digit pace in recent years. But corporate earnings are rising even faster. Yet companies are demonstrating a stubborn reluctance to pass on the benefit in the form of a dividend commitment.
Instead, company boards and managements have increasingly favored stock buybacks as a way to buoy their companies' share prices. In 2006, stock buybacks trumped dividends by nearly $260 billion and by more than a 2:1 ratio.
In buybacks, companies purchase shares of their own stock, thereby reducing the number of shares in circulation and increasing the value of those still outstanding.
Unlike dividends, stock repurchases do not have to appear on a company's balance sheet as a liability. They do not expire, and they can be executed at management's discretion. Thus, a company can buy back as many or as few as it wants, whenever it wants – or not at all.
A dividend promise, on the other hand, is more formal and less flexible. It is, essentially, an obligation.
The decline of dividends' popularity in the US can be attributed to several factors. Perhaps the most recent reason has been the rise over the past two decades of institutional investors, such as banks and pension and hedge funds, which view stocks as vehicles for capital gains (price appreciation) rather than income.
Another factor is that at one time US corporations were not allowed to repurchase their own stock. The practice was considered stock manipulation and was prohibited by securities regulators.
But that situation ended in 1982, when the Securities and Exchange Commission altered its policy in order to allow American companies to buy back their own shares.
Dividends took a hit when the 1986 Tax Reform Act revoked a law that had allowed individuals to receive dividends tax-free.
But even though in 2003 Congress cut the top federal tax rate on dividends to 15 percent – on par with the top rate on capital gains – companies continue to favor stock buybacks as a way to boost their share prices.
Many companies persist in the argument that buybacks are preferential to investors from a tax perspective. And they suggest there is no guarantee that the current favorable treatment of dividends will be maintained by the government in the future.
Regardless, the tax status of investors should not be the concern of companies' directors. Investors are capable of managing their own tax liabilities, and there are multiple options for reducing taxes.
The preference for stock repurchases probably has more to do with executive compensation than with concerns for investors.
Boosting a company's share price by reducing the number of shares in circulation is appealing to corporate executives who own stock options: The fewer shares on the market, the higher each share's price, and the greater the value of the executives' stock options. Dividends, on the other hand, profit them little.
Stock repurchases also may be preferable to dividends because they are easier to eliminate in the event that earnings turn south. Even though dividends are not guaranteed – and can be initiated, suspended, raised, or lowered at the discretion of company directors – such measures are taken with caution. Once a company issues a dividend, it becomes very difficult to cut or suspend it without investors at least noticing.
Nonetheless, there is a case to be made for companies paying dividends, out of principle: Shareholders, as owners of the company, deserve a slice of the earnings pie.
Give shareholders a cut of the profit
Ultimately, dividends let shareholders decide how they want excess cash deployed. If shareholders favor a share repurchase, they can use the dividend to purchase stock, which would put them in essentially the same position as if the company bought the shares. On the other hand, if shareholders prefer cash, they can simply bank the dividend. With dividends, investors actually can have their pie and eat it, too.
Dividends are likely to come back into fashion for several reasons: investors' growing demand for income, the need for companies to deploy excess cash, and management's desire to boost stagnant stock prices.
With stock prices peaking and large, mature companies having fewer opportunities to reinvest cash, dividends should regain their popularity as a way to distribute excess cash to shareholders. As stock prices rise more slowly, dividends are a way to return value to shareholders in lieu of capital appreciation.
There are some indications that companies are rediscovering the dividend as a way to engender goodwill among shareholders, even as their earnings growth slows. While the number of S&P 500 companies paying dividends is well below historical levels, it is still higher than in 2000, when just 317 companies paid dividends.
Another sign of the reversing trend is among technology companies, which are notorious for not paying dividends. In 2003, one of the granddaddies of them all, Microsoft, instituted a dividend.
The company's stock had been the fastest-growing stock on the market for 20 years, until 2000. At that point, growth slowed, and the company's stock price languished. Investors were not pleased and, consequently, Microsoft issued a dividend.
In general, companies that generate excess earnings have an obligation to give their investors a direct cut of the profit. Dividends should regain their footing as the primary way companies share the wealth with shareholders.