Everything being equal, a company that pays dividends is usually more expensive than the one that doesn’t.
The reason why is due to a number of factors. For one, investors typically think more about the present than the future. They like the idea of getting cash now as compensation for their investment.
Or maybe some investors don’t want to fuss over picking growth stocks. They just want the highest yield for their lump sum of cash.
A third reason why investors like dividend payers is because of what it says about the company. Having the luxury to pay dividends, the business must generate plenty of recurring cash they don’t necessarily need.
This is not just a widely-held perception. In Douglas J Skinner and Eugene Soltes’s 2009 paper, ‘What do dividends tell us about earnings quality?’ they found:
‘…dividends provide information about the quality of reported earnings, we find that the relation between current earnings and future earnings is stronger for firms that pay dividends than for those that do not.’
Skinner and Soltes go on to say (my emphasis):
‘The fact that we find that it is dividends per se that matter for earnings quality, rather than the amount of those dividends, suggests that dividend payers are a relatively homogeneous group for which earnings are of materially higher quality than those of nonpayers, which enables dividend payers to sustain economically meaningful regular dividends.’
Why dividend payers are a good long-term bet
With this in mind, would you prefer to buy companies paying dividends over those that don’t?
Say I gave you two options. You could either invest in company A or company B. Assume both have the same capital structure (same amount of debt) and earnings ($1 per share) at present.
The only difference between the two is that company A pays a dividend and company B doesn’t. And because company A pays a dividend, it’s slightly more expensive.
So, which one do you choose?
You might choose company A. Even though it’s slightly more expensive, the quality of their earnings is likely to be greater. And with your dividend payments, you could reinvest in other businesses, or take your family on a holiday.
Investing in company A is probably the safer choice. As stated in JP Morgan’s 2013 report, ‘Dividends for The Long Term’:
‘Over the long term, dividend-paying stocks have posted strong long-term returns with lower volatility than the broader market. While some investors may think of dividend payers as stodgy companies in slow-growth businesses — an outdated view from the 1980s and 1990s when capital appreciation dwarfed dividends — dividend payers can be found across a broad range of sectors and industries.
‘Dividends can sometimes serve as a good litmus test for companies with strong businesses and management teams that are committed to returning capital to shareholders.’
But that’s not to say you should always pick the dividend payer.
Why reinvestment returns should change your opinion
Let’s go back to our scenario and add in a few more assumptions.
Assume both company A and B can reinvest earnings at 10%. Company A only reinvests 50% of earnings. They use the other 50% to pay out as dividends. Company B on the other hand reinvests 100% of its earnings.
So, over five years, company A will grows earnings by 5% annually (0.5*0.10). And company B will grow earnings by 10% annually (1.0*0.10).
That means company A will grow earnings per share (EPS) from $1 to $1.28. And company B will grow EPS from $1 to $1.61.
Now, would this change your answer?
Let’s also assume investors like company A slightly more because of its dividends. They’re willing to pay 15-times earnings for company A and 12-times earnings for company B.
Therefore, over the five years, returns from company B (61%) would be far higher than company A (47%), even when you include dividends.
But reality is hardly ever this static. A company that grows earning by 10% each year is usually every expensive. Rates at which companies reinvest also differ from year to year. Even payout ratios change as management sees fit.
But even considering such variable changes, dividend payers could potentially do wonders for your portfolio.
Finding a growing income
Stocks that pay dividends aren’t always high-growth businesses that make you 10-times your initial investment. The reason why they pay out dividends in the first place is because they don’t have abundant activities that generate super-high returns.
But that doesn’t mean you can’t get both income and capital gains together. Take Astro Japan Property Group [ASX:AJA] for instance. The stock is a listed property group investing in Japanese real estate. The whole purpose of the stock is to pay out rental income to shareholders.
Over the past five years, AJA has paid out a growing income to shareholder. Annual dividends have increased from 5 cents in 2012 to 21 cents in 2016. Along with growing dividend payments, AJA has also appreciated 156%.
Yet not everyone has the time or expertise to find stocks like AJA. Which makes it harder to find income plays that can potentially make a difference to your portfolio. If you’re interesting in discovering some of the most overlooked dividend stocks on the ASX, click here to find out more.
Junior Analyst, Money Morning