Cash Dividends, Financial Theory And Investing For Retirement

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Includes: AMGN, GE, TGT, WMT
by: Gary Jakacky

With the need for baby boomers to supplement Social Security payments in their retirement years, the popularity of dividend investing has never been greater. Articles about "Dividend Aristocrats" are popular reading on Yahoo, Motley Fool, and of course here on Seeking Alpha.

I thought I would write briefly about cash dividends:

  • in corporate finance theory,
  • being viewed by boards of directors, as a practical matter, and
  • the consequence this has for investors seeking dividend income.

Without getting all technical, verbose and using academic-speak, in Financial Theory, cash dividend payments are viewed as a residual. What do I mean by this?

Suppose corporation XYZ has a net income of ten million dollars. The question now becomes, what should the company do with this "cash." Suppose the board of directors sees an investment opportunity (to expand sales, cut costs, whatever) which they feel will make the firm farm more profitable in the future. The cost of this project? Ten Million dollars. What should be the dividend payment to stockholders? Zero.

This is the case because the board of directors feels the investment project is a better use of the ten million, than just mailing it to shareholders.

Surprisingly, stockholders may feel the same way. Why did they buy the company's shares to begin with? They felt the board was better at finding profitable opportunities to begin with.

Think about it. Why might you buy shares of Amgen? (NASDAQ:AMGN) Maybe because they know more a bit more about biotechnology than you do? Wouldn't you prefer they invest in new drugs and procedures instead of sending some cash back to you, which you might spend on coffee?

Thus Finance theory suggests dividends should only be paid from the residual cash left over after all investment opportunities have been exhausted.

Oddly, this means in financial theory companies which pay cash dividends are saying they don't see enough opportunities to invest in to absorb all their cash. It is almost an admission of defeat. "Here! Have some money back. We don't have any better use for it!"

At times in the past, when dividends were much less popular (for example, the late 1960s) this attitude was prevalent on Wall Street. Fast growing technology firms like Control Data and Fairchild Camera were expected to retain earnings and generate capital gains through profitable new products and services. Much the same attitude prevailed through the boom years of the late 1980s and 1990s. Paying a dividend was seen as stodgy and old fashioned.

Financial theory is one thing: running a corporation and keeping stockholders happy is quite another. Few, if any companies follow a "residual dividend policy" as suggested by textbooks. It would make the payment of cash dividends far too volatile from year to year, for one thing.

Furthermore many companies finance expansion through the issuance of debt (long and short term) since the latter receives better tax treatment.

Instead, most boards follow what is a called a "signaling" policy when paying dividends. This policy means you pay dividends (and more importantly, increase the dividend payment) when you wish to signal to shareholders that your current level of profitability has reached a permanently higher level: and that is now safe and prudent for the company to increase its payout.

As a practical matter, this means boards will pay out only a fraction of net income (the "payout ratio" that dividend recipients watch like a hawk). Increases in dividends will always lag behind increases in earnings. This gives the board a "cushion" in the event that earnings fall back for a few quarters or even a few years: they won't need to cut the dividend back. A dividend cut is viewed as a very negative signal, that management sees earnings growth in peril.

Companies, like leopards, tend not to change their stripes. By looking at long term earnings and dividend payments you can see if this is the policy your board follows. (There are others). A few examples.

source: www.bigcharts.com

Notice that Wal-Mart (NYSE:WMT) raises their dividend only after a full year of quarterly earnings increases justifies confidence the payout can rise. With over $5 in earnings and a payout of $1.88 over the four quarters, the company has plenty of room to keep dividends the same should earnings encounter some short term headwinds -- headwinds, perhaps, like Target (NYSE:TGT) has encountered in the past and may again, given unfavorable recent publicity about data breaches. Should shareholders worry about the dividend? I don't think so:

Because Target's management was cautious about dividend payments early in the previous decade, they did not need to cut the payout as earnings fell. In fact they increased them! Even as share net fell a bit. Notice how much less volatile the dividend is than the share price. Should shareholders be worried about the a dividend cut now? It appears unlikely.

Proof that Wall Street sees a dividend cut as a seriously bad signal from management can be seen by looking at the "bluest of the blue chips," General Electric (NYSE:GE). GE is the only surviving member of the original Dow Jones Industrial Average, compiled first in 1896.

No matter how farsighted the GE board was, foreseeing the problems with their high debt and the oncoming severe recession, the cut in the dividend did not sit at all well with investors. Sure ... markets, as they do, saw the dividend cut coming, slashing the share price by eighty five percent. In the worst of the crash one of the company's light bulbs cost more than their shares!

The company promptly returned to a slow growth dividend policy as soon as profitability stabilized. And yes, share prices have begun to recover. But GE remains well below its 2007 high, while many stocks have surpassed that peak. Investors have a long memory.

What does this mean for those seeking dividend income in retirement? I hesitate to place too much emphasis on an example such as the severe recession a few years ago. Still ... keep an eye on that payout ratio. A glance at Value Line data shows that GE traditionally paid close to 50% of earnings as cash dividends. Wal-Mart is closer to 30%. Many other aristocrats are similar.

I wish I could say diversification across industries would help. But even in a recession milder than the 2008 debacle, the vast majority of companies experience difficulty maintaining sales growth and earnings momentum. You would be better off looking at financial strength: look for red flags like high debt, poor interest/cash flow coverage, and yes, a rising payout ratio.

These are easy balance sheet and income statement categories to follow. If you do so you can avoid pitfalls like GE's dividend cut and assure yourself of a reliable dividend income through retirement.

Disclosure: I am long XLV, IHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.