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Why an old-fashioned financial tool is worth a second look.
Don Durfee, CFO Magazine
August 1, 2006
This is the age of the share buyback. With record amounts of cash swelling corporate bank accounts, companies are increasingly giving money back to shareholders by buying their own stock. Over the past year and a half, companies in the S&P 500 have spent a staggering $515 billion repurchasing their own shares.
Dividends aren't nearly as popular. While companies are paying more of them these days — at least partly because of the 2003 tax cuts on capital gains and qualified dividends — the ratio of dividends to earnings is close to its lowest level since the late 19th century.
It's no secret why buybacks dominate. They are tax-deferred, while dividends are still subject to a 15 percent tax. They are also one-off: repurchasing $50 worth of stock today doesn't create an expectation that you'll do the same next quarter. Cancel a dividend, however, and you are alerting the market (and your competitors) to a cash-flow problem. Finally, many people assume buybacks to be a better way of boosting the stock price, since reducing shares outstanding raises earnings per share.
But companies may be underestimating the humble dividend. Demographics and market conditions are creating a large group of investors that will increasingly demand income-producing stocks. Furthermore, there is new evidence that for companies able to make the commitment, dividends may provide a bigger boost to share price than buybacks.
Not Just for Widows and Orphans
During the boom years of the 1980s and '90s, most investors greeted dividend announcements with a yawn. What was the point of a dividend yield in the low single digits when share prices were rising so sharply? Now, investor attitudes are starting to turn. Asset prices are only creeping up, and few analysts expect that to change any time soon.
"In this market, the dividend makes a great difference to overall returns," says Greg Church, chief investment officer of Yardley, Pennsylvania-based Church Capital Management, which manages $2 billion in assets. "If capital appreciation is in the 7 to 8 percent range, a 3 percent yield gets you into double digits."
Over time, that additional yield can add up. Since 1926, dividends have accounted for 41.1 percent of the total return of the S&P 500, according to Standard & Poor's. Furthermore, the return from dividend-paying stocks is less volatile, thanks to the steady flow of income. All of these features make dividend-paying stocks more alluring — particularly to the hordes of baby boomers on the verge of retirement. And the boomers are starting to make their wishes known. "We're starting to see enormous pressure from individuals and some institutions for dividends," says Howard Silverblatt, senior index analyst with Standard & Poor's.
One sign of this is the willingness of investors to applaud dividend payments by companies that would have been unlikely candidates just a few years ago. For example, when Pegasystems Inc., a Cambridge, Massachusetts-based software maker, announced its first-ever dividend in June, its share price traded up 5 percent on the day of the announcement. "We were a little worried," admits interim CFO Shawn Hoyt. "We're a small tech company. Would investors think that this contradicts our growth story? As it turned out, the reactions were positive or, at worst, neutral."
That jump in Pegasystems's share price doesn't appear to be an anomaly — in fact, it's smaller than most. Boston Consulting Group (BCG) recently examined more than 300 cases in which companies announced large dividends or large buybacks. After two quarters, the dividend announcements had produced a median 23 percent boost in the company's price-earnings ratio relative to the S&P 500 average. The effect of buybacks? A -0.6 percent decline. "There's very strong statistical evidence that dividends increase P/E multiples," says Eric Olsen, a senior vice president in BCG's Chicago office. "But we haven't seen any evidence that buybacks move P/E multiples."
Over the long run, dividend-paying stocks do even better. A study by Ned Davis Research, a firm that advises institutional investors, found that from 1972 to 2005 dividend-paying stocks dramatically outperformed the market. Companies paying regular dividends returned 10.1 percent annually, compared with just 4.1 percent for those that didn't.
Signaling the Future
What explains such differences? Part of the reason for the long-term performance is simply the added returns produced by the dividend yield. There is also the signaling effect: because dividends are hard to reverse, you don't announce them unless you feel confident that you can pay them again and again. By this reasoning, buybacks count for less.
The desire to make such a statement about its future is one reason why Cardinal Health recently doubled its dividend and then raised it another 50 percent. "The message we want to give to investors is that we have a stable, repeatable, and growing cash flow," says senior vice president and treasurer Linda Harty.
But there's something else at work. A 2003 study by Clifford A. Asness, managing principal of AQR Capital Management, and Robert D. Arnott, chairman of Research Affiliates, found that the size of a company's dividend is a good predictor of its future earnings — the bigger the dividend, the higher the earnings. That is exactly contrary to common wisdom, which holds that a growth company serves shareholders best by putting its earnings back into the business. The reason, hypothesize the authors, is that dividends force discipline on managers.
With a lot of cash on hand, "there's always the risk that you'll squander it or get lazy," observes Silverblatt. "It's always better to be a little hungry."
Don Durfee is research editor of CFO.