Dividends or No Dividends, That Is the Question

 |  Includes: CAG, D, DD, DOW, FCX, KMB, MMM, PTR, SYY, T, VZ
by: Marc Courtenay
To buy stocks with big dividends, or not to buy, that is the question! The answers on this subject are as manifold as the number of plays written by Shakespeare.

A book that recently came to my attention "Investment Fables" delves into this topic and it serves as a good reminder to why dividends can make a difference.

Then my friends at Motley Fool Income Investor started toying with this "sweet dilemma" and came up with some opinions of their own that echo my perspective, so allow me to share some of what they shared with me. Their analysis is very instructive for those of us who want to be better "value" investors, as well as "growth with income" investors:

"Companies that pay dividends reward investors with both income and potential stock appreciation over time. The dividends received from stocks are usually less than the coupon payments from bonds, but the potential price appreciation is much greater with stocks, thus setting up the classic trade-off between fixed income and equity investments.

"But what if you could capture the best of both worlds -- high-yield income with the appreciation?

"This seemingly anomalous idea is one of the cornerstones of the high-dividend investment strategy. Some companies pay such high dividends that their yield matches or exceeds that of a risk-free bond. Here's a list of some larger companies whose trailing dividend yield exceeds that of the current U.S. Treasury Bond rate.

Source: Yahoo! Finance. As of Feb. 12.

"By holding these stocks, an investor can make more than investing in bonds without the stock ever appreciating. Any appreciation in the stock is considered an added bonus.

Another reason why the high-dividend investment strategy is appealing is that many of the companies that pay high dividends are larger and established, making them less risky.

During a recession or bear market, investors typically flock to these stable securities, because the income received from dividends can offset or alleviate some of the value lost in the stock price."

Why dividends make better sense

So do dividend-paying stocks really make better investments than their non-dividend-paying counterparts? Well, like anything in this world, there are various schools of thought on this matter, and we have seen that dividends can be reduced or suspended, as the recent decisions by Dow Chemical (NYSE:DOW) and Freeport McMoran Copper and Gold (NYSE:FCX)..

Some investors believe it is better to invest in non-dividend paying stocks, because the earnings can be reinvested back into the company to generate more growth or to make acquisitions.

Also, earnings that are paid out in dividends are taxed twice, once at the corporate level and again for the investor. Reinvested earnings are only taxed at the corporate level, allowing more cash to generate higher compounded returns.

Here's a point that does resonate with me, and that's the argument that dividend-paying companies are superior investments because they show that management is committed to its shareholders. Paying dividends takes cash out of the hands of management -- which can't always be trusted to make decisions with the shareholders' best interests in mind -- and gives it directly to investors.

On the other hand, do I want to invest in a company who has the kind of management that I can't consistently trust to look after my best interests as well as the company's?

Sustainable Dividends

For those who see this income as a benefit, there are two important things to keep in mind. First, investors must understand how much a company can "afford" to pay in dividends. If a company is paying out unsustainable dividends, it's only a matter of time before the dividend will be cut. This is one of the risks of investing in high-dividend equities instead of bonds. People who invest in bonds are guaranteed a coupon payment until the bond matures. In contrast, equity investors have no such guarantee on their dividends, while companies have the freedom to cut or cancel their dividend payments at any time.

To reduce their risk, investors must calculate the company's free cash flow to ensure that it exceeds the amount being paid out in dividends. Free cash flow, unlike net earnings, tries to measure the amount of cash a company has left over after all of its reinvestment needs have been met. When a company's dividend payout exceeds its free cash flow, it is not only reducing its asset base, but it may not be reinvesting enough to sustain itself. Over an extended period of time, this can increase investors' risk. So we'd better keep a wary eye on levered free cash flow numbers, which aren't always easy to find.

Do dividend-paying companies still experience growth?

The second thing to keep in mind is a company's long-term sustainable growth rate. This is very relevant to the question of investing in company's with generous dividends.

A company grows based on how much it reinvests and the quality of its investments. Companies that pay out dividends have less capital left over to reinvest; therefore, their long-term sustainable growth rate is expected to be less than the return on equity. As the payout ratio increases, the chance for price appreciation decreases, along with the diminishing expected growth rate:

Expected Long-Term Sustainable Growth Rate = (1 - Payout Ratio) times the (Return on Equity)

The Motley Fool group gave a good example,

"... let's assume that a company pays out 60% of its earnings in dividends and currently generates a 12% return on equity. Assuming this trend continues, the expected long-term sustainable growth rate would be (1 - 0.60) times (0.12) = 4.8%."

The bottom line here is investors seeking both price appreciation and dividends need to make sure that the company can still grow its earnings. This takes the ability to do some number-crunching similar to the equation listed above. This should be done BEFORE you invest in a company to begin harvesting the dividend yield.

Recently I did that before I invested in some shares of Verizon (NYSE:VZ) and AT&T (NYSE:T), both pay over a 6% dividend and if my numbers were correct, they should be able to sustain their dividends while experiencing some sustainable growth as companies.

Disclosure: long DD, FCX, T, VZ