Your Dividends May Be Costing You Money

Why dividends?

As people get older, they often say that they need their dividends to live on, because they don't want to dip into their capital. The problem is that by aiming at stocks with higher dividends they may actually be destroying their capital at a faster rate. Doing so may be more damaging than if they were to sell small parcels of shares to meet ongoing living expenses.

First of all, a dividend yield is the ratio of dividends per share over a year, divided by the price of the stock. For example, over the past year Duke Energy (DUK) had dividends of $1.10 while its price in early March was around $27. This gives a dividend yield of 4.07%. It is similar to the rate on bonds, except that the calculations are based on the share price instead of the face value of the bond.

In most years, the sector with the highest average dividend yield is electric utilities. The current average dividend yield is around 6%. The sector with the lowest dividend yields is usually software, since most of these companies pay little or no dividends. But things are changing; recently, Microsoft (MSFT) started handing out a small amount of its capital reserves as dividends. It made its first small dividend of $0.08 for the March quarter in 2003, skipped a couple of quarters, and then made a second payment of $0.16 for the December quarter.

Since the price of Microsoft last year was around $26, this gives the stock a dividend yield of approximately 0.9% (= 0.24 / 26) for 2003. In the 2004 financial year it made two payments of $0.08.

A tale of two investors

Consider two investors, John and Jill, brother and sister. From the time they were toddlers, their father told them over and over not to sell shares. "They are your capital, and you have to preserve your capital at all cost," he would say.

With this idea drummed into him, John came across Duke Energy back in 1998. For the previous five years, the stock had paid an annual dividend of around $1.00 with $1.08 in the previous year. This meant an average dividend yield of between 3% and 5%. At the start of 1998, the price was $27. Now, suppose John bought 1,000 shares for a total of $27,000. Each year since then, Duke paid a dividend of $1.10. So each year John received a total dividend of $1,100 per year toward his living expenses.

When John first invested in DUK back in 1998, this was a dividend yield of 1.10/27 = 4.1%. Not bad, John thought — a certain payment each year at an initial rate of 4.1%. Unfortunately, although Duke hit a high of $47 in 2001, by the start of 2003 it had crashed to $12. Even though John had received $1,100 each year and he still had the 1,000 shares he started with, his net worth had remained at $27,000.

John's sister, Jill, remembered their mother had a different view, that money was money. "Make the best investments you can," she always said. "When you have to pay your bills, pay with money that is the cheapest and that will have least effect on your future finances."

Like John, Jill also had $27,000 to invest back in 1998. She had shopped at Bed Bath and Beyond (BBBY) for 10 years and liked what she saw. She discovered that it was expanding across the US, so Jill decided to invest her $27,000 in BBBY.

John also did some research on the company. He discovered that it did not pay any dividends and was not likely to pay any in the foreseeable future.

When he confronted Jill with this news, she replied that she already knew that. "I am still going to invest in it," she told him.

"Well, don't come to me when you need money to live on," he flung at her as he left.

At the start of 1998, the price of BBBY was $9.90, so Jill bought 2,727 shares. At the end of the year the price was $16.00, so she sold 68 shares to get $1,100 in cash, the same amount that John received from his dividends. This left her with 2,659 shares. At the end of 1999 the share price was $13.60, so Jill sold another 80 shares to get another $1,100 in cash, leaving 2,579 shares. Repeating this sell process each year left Jill with 2,449 of her original 2,727 shares in 2004. Figure 1 shows Jill's share transactions.

Figure 1: Jill's share transactions.

John accused Jill of dipping into her capital each year. He predicted a dire outcome because the number of shares she owned had dropped by 275 or approximately 10%. But Jill was not worried. She saw that the worth of her shares, her wealth, had grown from $27,000 to more than $100,000.

There are a number of morals in this example:

1)Don't confuse a decreasing number of shares with decreasing wealth. Even if the number of shares go down, your total wealth may well be going up.
2)Always make the best investment you can in terms of total return and don't just focus on capital gain at the expense of dividends or vise versa.
3)Don't panic if you have to sell some shares to live on.

You might think I picked unfair examples here and that, on average, it is better to choose stocks with higher dividend yields. That way, you could argue, you are at least increasing the chances of getting a higher total return.

This is partially true. These days, more and more companies are paying dividends, mainly to keep their shareholders happy, particularly in the light of the new laws on the taxation of dividends.

Double taxation and tax relief

It used to be that dividends were taxed twice. Firstly, the company was taxed at the company rate on money to be distributed as dividends. In other words, the company paid its dividends in after-tax dollars. Secondly, the shareholders were taxed at their marginal rate (which could be as high as 38.6%) on these dividends.

However, at the start of 2003, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) was passed. Part of this act was to reduce the dividend-tax rate to 15% for most taxpayers (5% for taxpayers in the lowest two tax brackets). In each of the three quarters following the tax bill's enactment, an average of 65 dividend-paying companies increased the size of their dividends by 20% or more, compared to an average of only 32 companies in prior years. Moreover, in the year following enactment, 113 publicly traded corporations initiated dividend payments for the first time, compared to an average of 22 companies in prior years.

Overall, this is good news that dividends won't be taxed twice. Although not everyone agrees. In an opinion piece in The Washington Post, Warren Buffett wrote that this action would "further tilt the tax scales toward the rich." Putting this aside, as we shall see, much of the benefit may be overshadowed by the issues related to capital gains.

Should a company pay dividends?

It is important for investors to understand what is happening when a company pays dividends. Basically, there are four things that management can do with the money that it earns. It can:

1)Pay it out as dividends,
2)Use it to buy back shares,
3)Invest it within the company, or
4)Purchase other companies.

Of course, a company can also apportion the money between these options, and the decision should depend on how well management is using existing funds and the opportunities to use extra funds.

The easiest way to measure how well management handles its money is by looking at the return on equity (ROE) and return on capital (ROC) ratios. ROE is defined as the earnings of a company divided by its equity. In turn, the equity of a company is defined as its total assets minus all its liabilities, or roughly, everything that it has less what it owes. ROC is similar except that it makes allowance for the long-term debt of the company and interest paid on that debt.

If a company has a low ROE and ROC, then it makes sense to pay out its earnings as dividends (or buy back shares). On the other hand, if a company has high levels of ROE and ROC, then savvy investors recognize that it is better for the company to keep the money. Such companies are likely to receive a higher return on available funds than individual shareholders.

The payout ratio is the proportion of earnings a company chooses to pay out as dividends. A payout ratio of 0% means no dividends, and a payout ratio of 100% means that all the earnings are paid out as dividends. (Some companies do not have this flexibility. For example, by law, real estate investment trusts — or REITs — must pay out 90% of their taxable income in the form of dividend payments to shareholders.)

Using the companies in the Standard & Poor's 500 index as a starting point, we remove those companies that have given a special dividend in the last 12 months. The result is that 25% of the remaining companies pay no dividends. The average ROE for these companies is 9.67% compared to 18.84% for companies that do pay dividends. In other words, on average, the actions of managers are back to front. The companies making the best use of their money as measured by return on equity tend to pay dividends, whereas companies with lower ROEs tend not to pay them.

The results for ROC are similar. Figure 2 summarizes the outcome for ROE and ROC. One explanation for this is that if a company has a low ROE or ROC, they are struggling and may be looking for a turnaround. Hence, they are reluctant to part with any of their earnings.

Figure 2: Return on equity and return on capital. Here you see the returns for dividend and nondividend S&P 500 stocks.

What does this mean for individual investors?

Warren Buffett, the record-breaking chairman of Berkshire Hathaway, puts a lot of emphasis on companies with solid return on equity. Every year in the annual report of his company he writes that he is looking for companies with a "high return on equity and not too much debt."

Using this as a first indicator, based on the principles of professionals like Buffett, we might be able to use dividend yield as a second indicator of a company with strong management.

Taking the S&P 500 companies, I separated them once again into those paying dividends over the past year and those not paying dividends. I looked at the total returns over one year and five years for these two groups. (Total return is the combined return from capital gains and dividends, calculated by assuming that dividends are reinvested.)

The basic result is that companies that paid a dividend outperformed those that did not. The results are displayed in Figure 3.

Figure 3: Average total return. Here you see the one- and five-year returns for dividend and nondividend-paying S&P 500 stocks.

Does this mean that we should aim at stocks that pay the highest dividend? Well, no. There is actually an inverse correlation between the dividend yield (assuming that the company pays any dividends) and the total return. You can see the trendline for this correlation in Figure 4 for S&P 500 companies over 2004.

Figure 4: Returns vs. yields. Here you see the one-year total return versus dividend yield for S&P 500 stocks that pay dividends. The line is the regression line.

Since total return incorporates both dividends and capital gains, the chart shows that if there is a low dividend yield, on average the financial loss to the investor is more than compensated for by higher capital gains. As we move along the horizontal axis to the right and consider that companies have higher dividend yields, on average their capital gains decrease faster than the increase in dividends.

Conclusion

Some analysts and newsletter authors strongly favor companies that pay dividends. For example, Geraldine Weiss, the former publisher of Investment Quality Trends, wrote: "When all other factors which rate analytical consideration have been digested, the underlying value of dividends, which determine yield, will in the long run also determine price."

However, it is not quite that black and white. Many quality stocks have never paid dividends and have stated their intention not to do so in the future. For example, Berkshire Hathaway has never paid any dividends and has had an average annual total return of 15.3% over the past 10 years, and even higher before that.

If you do want to seek out companies with dividends, on average it is the companies with the lower dividend yields that provide the best performance. But whether or not there are dividends, at the basis of your investment is a company with real products and services. In the end, it is how well that company performs as a business that will determine your return over the medium to long term.

John Price has developed Conscious Investor, an investment system based on the methods of Warren Buffett. The software scans 10,000 US and Canadian stocks looking for quality companies selling at profitable prices.

Suggested reading

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.