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I attended a conference in New York last October where John Paulson was the keynote speaker. One of his supporting arguments on a bullish stock market was that the current S&P dividend yield was very comparable to or even better than the treasury yield. He told the audience that from that standpoint, the stock market was undervalued.

I beg to differ. Dividend yield by itself means nothing. It is fundamentally a product of a capital structure decision, and not necessarily an indicator of the valuation, growth prospect, or the quality of underlying stocks.

Just imagine that you are the CEO of a family business. You are making a decision on how to deal with the profits from the business from last year. You obviously need to decide how much of that profit should be reinvested into the business and how much should be distributed as dividends to the family shareholders. If the distributed dividend is to be deposited into a bank to earn interest, while the reinvested profit is put to work for the next year, the family shareholders (hopefully not the in-laws) would probably favor one option or the other depending on the rate of return differential.

Suppose the dividend that stays in the bank would only produce 0.5% and the reinvested profit would generate 10% profit the next year. In this case, the decision may be simple: let the money compound in the business since the marginal return of one additional dollar would bring a 10 cent profit. Conversely, if the business's prospect next year is not so good, a dollar's investment might bring red ink, then maybe that safe 0.5% bank rate is suddenly attractive.

Today the S&P 500 companies are paying a lot of dividends and buying back their own shares in the open market. Typically these actions have been touted as "returning money to shareholders." But they just don't bother to explain why the cash could not be put to productive use in their own business. The economic downturn and huge uncertainty make reinvesting less attractive to company management. That's why they leave the decision of reinvesting to their shareholders: Here is your money, you do whatever you like; anyway we could not make a good return on this money for you ourselves.

Any company's capital comes from only two places: shareholders' equity or debt. Paying out dividends means reducing the shareholders' equity portion. That has the effect of altering the debt/equity ratio. The ratio is important to the business. For one thing, the risk profile (bankruptcy risk) may be altered. A high debt load usually raises the risk of going out of business. A bankrupted company will not pay dividends anymore. The investors in shipping companies may have learned the hard way. Just a few years back, many investors were sucked in the high dividends yields that were offered by the shipping companies, such as Frontline Ltd. (NYSE:FRO) and General Maritime Corp. (filed bankruptcy: GMRRQ). When time was relatively good, the companies were paying out generous dividends. Had they known the subsequent straits thanks to the cyclical downturn of shipping industry, they probably would stay away from such dangerous game. Another role this ratio affects is called "cost of capital," which is a fancy word for the aggregate price of using debt (interest) and equity (shareholders' required return). The cost of capital has ramifications when a project is to be launched since the rate of return has to be higher than the cost of capital to make sense. Because of the ultra low interest rate environment, the cost of capital may be lowered by increasing debt and lowering equity. Indeed we have recently been seeing slews of companies issuing debt and paying out huge dividends at the same time.

A case in point: Microsoft (NASDAQ:MSFT). Microsoft used to be stingy in paying out dividends when acting as a growth company. However, with the tremendous cash hoards doing nothing on its balance sheet, the company's management responded to shareholders' request and started paying dividends just several years ago. Interestingly, it borrowed roughly $6 billion and paid out dividends of $5 billion in FY 2011. Of course there is no need to borrow a dime to pay that dividends, and the decision is mainly based on capital structure as well as taking advantage of the near zero interest rate.

One last idea: the dividend amount doesn't rely on the profitability of a business. The business may issue dividends even when deep in the red and when hemorrhaging a lot of cash. As long as there is some cash in the coffer, the company may pay out any arbitrary amount of dividends (sometimes subject to debt holders' convenience).

Can this dividend yield game continue indefinitely? Hardly! There are limits to eventually how much in dividends will be available for shareholders. The debt/equity ratio has to remain healthy and prudent; the company has to have cash to pay dividends; the company sometimes has to reinvest in itself to stay competitive in the marketplace. Good things don't last forever, and high dividend yield probably won't either.

Many investors today are clamoring for any return higher than the risk-free rate. This alone explains a lot about irrational investment decisions. Dividend play is getting popular again these days based on this craving for returns at any cost. I have to say that there is no sound foundation if dividend yield alone is the determining factor for one's asset allocation.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: High-Yield Dividend Risks