Why Dividends Matter For Investors?

Do dividends matter for investors? What are the benefits of dividends? The astronomical growth in the stock price of some companies that do not pay a dividend has led some investors to believe that dividends do not matter. For instance, Amazon (AMZN) does not pay a dividend, and arguably the stock keeps going up over time in anticipation of more future growth. Hence, some investors have then concluded that dividends don’t matter.

However, the short answer is “Yes, dividends matter for investors.” There are distinct benefits of dividends to investors. In aggregate, dividend-paying stocks provide higher returns with lower volatility than stocks that do not pay a dividend. Dividends are a return of cash to shareholders. Further, dividends have provided nearly 40% of total return over long periods. Some investors also rely on dividends for income. So, dividends have benefits for investors.

We will first discuss and summarize dividends and then answer the question posed in this article.

What Is A Dividend?

Dividends are typically cash distributions that public companies pay out periodically from their earnings to shareholders. Most companies pay dividends quarterly in the U.S. Some companies pay dividends monthly, and a few pay dividends bi-annually or annually. It is much more common for a European company to pay a dividend bi-annually or annually.

Dividends are a type of income that shareholders receive for each share of stock that they own. For example, an investor holds 100 shares of Company A. Let’s assume that Company A pays a dividend of $0.10 per share. This fact means that the investor receives $10 in cash.

Some companies also pay stock dividends. A few companies pay both cash and stock dividends. An excellent example is Tootsie Roll (T.R.), which pays a cash dividend of $0.36 per share and a ~3% stock dividend annually.

A few companies pay special dividends, which are much more infrequent and can be paid at any time. For example, Costco (COST) is a company that pays a special dividend every few years. Before COVID-19, there were a few companies that paid an annual special dividend. One example of this was Cracker Barrel Old Country Store (CBRL). But the number of companies cut or suspended their dividends due to the coronavirus pandemic reduced this list.

Regardless of the type of dividend, dividends are set and approved by a company’s board of directors and the shareholders.  A dividend payment has four parts: an announcement or declaration date, an ex-dividend date, a record date, and a payment date.

A Brief History of Dividends

The history of dividends is an interesting one. It starts in 1602 in Holland. In the United States, York Water Company (YORW) starts its streak of consecutive dividend payments in 1816. The company has over 200 years of paying a dividend. It is also the oldest publicly traded utility in the country. Fast forward to modern times, and Microsoft (MSFT) starts paying a dividend, followed by Apple starts paying a dividend in 2011.

In the U.S., dividend yields averaged about 5% from 1871 to 1982. The bottom of the bear market in that year and changes in investment outlook, creation of the 401(k) plan in 1980, proliferation of tax-deferred savings, and lower taxes on capital gains versus dividends pushed the average dividend yield down from roughly 5% to about 2.5% from 1983 to 2010. It hit a low of about 1.1% in 2000. Today, the average dividend yield is even lower at about 2%.

In general, equity prices have grown faster than dividends since 1983, causing a drop in average dividend yield. That said, it is clear why dividends matter to investors over their history. Both investors and companies understood the benefits of dividends for essentially the inception of the idea. Dividends provided a substantial part of the total return in the past.

Dividend Metrics

There are two primary metrics for dividends: dividend yield and payout ratio. Of course, there are other metrics and calculations, but these are the two most fundamental.

Dividend Yield

The dividend yield shows the annual rate of return that a shareholder receives from the dividend. It is a measure of valuation since it depends on the share price. Hence, it is a way to measure the return of the dividend of any new purchase. The dividend yield is calculated using the following equation:

Payout Ratio

The payout ratio is an indication of dividend safety and the financial condition of the company. It depends on annual earnings. If the dividend takes is too high a percentage of the earnings, it is likely not safe. Dividend payout ratios over 100% mean that the earnings do not cover the dividend payout. The following equation calculates the dividend payout ratio:

Do I Need To Pay Tax On Dividends?

The short answer is “Yes.” The IRS considers the dividend to be income. This fact is the case even if you reinvest all your dividends through a DRIP stock plan back into the same company.

Despite being considered income, dividends can be taxed at a lower rate than your regular income if it is a qualified dividend. This is because qualified dividends are taxed at the long-term capital gains rate.

Ordinary or non-qualified dividends are taxed at your regular income tax rate, typically higher. For example, distributions from REITs, MLPs, and some other types of special entities are not considered qualified dividends.

Dividend Tax Rates

The differences in dividend tax rates can be significant, especially at high incomes, one of the essential benefits of owning stocks that pay dividends. Nevertheless, it is clear from comparing tax rates between regular income and qualified dividends, owning dividend paying stocks is advantageous, especially at higher incomes.

Which Companies Pay Dividends?

Typically, large established companies with stable earnings and cash flow pay dividends. But established small-cap or mid-cap companies with similar characteristics may also pay dividends. In addition, companies in specific sectors tend to pay dividends more often. These sectors include consumer staples, utilities, oil and gas majors, financials, and healthcare. Consumers staples companies and utilities are favorites of investors seeking dividends. For example, Coca-Cola (K.O.) has paid a growing dividend for 58 years. The current dividend yield is approximately 3.5%. The combination of dividend yield, dividend growth, and some capital appreciation has been very popular for dividend growth investors.

Master Limited Partnerships (MLPs)

Companies structured as master limited partnerships or ‘MLPs’ pay a particular type of dividend called a distribution since they must do so. MLPs are typically pipeline companies and are referred to as midstream companies. They store and transport oil, natural gas, and chemicals. MLPs are pass-through entities, so they are not the same as regular corporations. Instead, MLPs pass through cash flow as distributions.

Real Estate Investment Trusts (REITs)

Companies structured as real estate investment trusts or ‘REITs’ also pay dividends. REITs are also pass-through entities. They pay no federal income tax as long as the REIT pays out at least 90% of its taxable income as dividends to its investors. For this reason, REITs are also dependent on capital markets to fund future growth. They must issue new debt or additional equity to fund acquisitions or new projects. Dividends from REITs are not qualified.

Dividend Growth Stocks

This blog and focus have been, for the most part, dividend growth stocks. These are stocks that pay a growing dividend over time. There are several advantages and risks to dividend growth investing. This type of stock is categorized by the consecutive number of years that a company pays a growing dividend.

Companies that have done so for 50+ years are referred to as Dividend Kings. Companies that have paid an increasing dividend for 25+ years are known as Dividends Champions. Those that have increased the dividend for 10 – 24 years are called Dividend Contenders. Lastly, companies that have raised the dividend for 5 – 9 years are known as Dividend Challengers. Take a look at the dividend stock lists in the different categories mentioned above.

Why Dividends Matter to Small Investors?

What are the benefits of dividends? Dividends are passive income based on an initial investment by investors. A small investor can use the distribution for multiple purposes, including reinvestment in the same stock, investment in another stock, spending, and other purposes. Reinvesting dividends in the same stock is a powerful method to build wealth by compounding. This combination of reinvesting the dividend and incrementally buying additional shares in stock is referred to as a dividend growth investing strategy. Since you are reading this blog, you are likely aware of how compounding works for regular savings accounts. But it can also work for dividend stocks through dividend growth investing.

Moreover, some professionals agree. Michael R. Acosta, CFP®, ChFC®, CSLP® of the Tom Dumas Team at Consolidated Planning, Inc., says,

“Dividends can be very important to some investors depending on their risk appetite or where they’re located on the spectrum toward retirement, i.e., accumulation phase, capital preservation phase or distribution phase.  More often than not the consistency and commitment to paying a dividend as a company can signal the financial strength and wellbeing of said company. For example, Procter & Gamble has paid a dividend every year since 1891.  This does not mean that their stock price has increased or gone up year-over-year but their commitment to sharing in revenue has provided great value to shareholders.”

He also states  

“…dividends can be very valuable if the investor is seeking to own time tested companies and predictability around income or ability to purchase more shares of a company through dividend reinvestment.”

Dividends Can Be Used to Determine Valuation

Dividends can be used to determine valuation—the Gordon Growth Model values stocks based on constant dividend growth rates. The Gordon Growth Model (GGM) or the Dividend Growth Model is used to determine the value of a stock based on the current dividend per share and its expected constant growth rate. The Model calculates the intrinsic or fair value of a stock, and thus it ignores current market conditions. This model is a simplified version of the Dividend Discount Model.

The Gordon Growth Model provides a relatively quick and straightforward way of determining stock valuation with only knowledge of the dividend per share, an expected rate of return, and the expected dividend growth rate. There are some limitations to the Model, and you can check the more in-depth article about those. Still, it works reasonably well for mature companies with relatively predictable and stable dividend growth rates. However, one should always compare the results of this Model with other valuation methods.

Dividend are an Indicator of Financial Health

The first benefit of dividends is that they are an indicator of the financial health of the company. In general, a dividend requires a company to have positive earnings and cash. From this perspective, dividends cannot be gamed by corporations. Companies can only pay the dividend so long if it is not covered by earnings or cash flow. If earnings and cash flow do not cover the dividend, the dividend can be cut or suspended. For instance, during periods of financial distress, e.g., the COVID-19 pandemic or a sub-prime mortgage crisis, dividends were cut and suspended by many companies. Furthermore, a company that consistently raises the dividend annually usually grows top and bottom lines over time.

Dividend Contribution To Total Return

The second benefit of dividends is that they have provided a significant percentage of total return over extended periods, as seen in the chart below. It is roughly 41% of total returns for the S&P 500 from 1930 to 2020. The actual percentage that dividends contribute to total varies per decade. It was as high as 73% in the 1970s. However, it was as low as 16% in the 1990s. This was a period dominated by relatively new and rapidly growing tech and telecom stocks. At that time, these stocks did not pay a dividend. As a result, in the 2000s, the S&P 500 had a negative total return, but dividends offset price declines.

Average Annual Returns and Volatility by Dividend Policy

Importantly dividend payers and dividend growers tend to provide better market returns with lower volatility in aggregate, which is the third benefit of dividends. According to Ned Davis Research and Hartford Funds, from 1973 – 2020, dividend growers and initiators had an average annual return of 13.20% with a beta of 0.88 and a standard deviation of 16.08%. Dividend payers provided an average annual return of 12.83% with a beta of 0.94 and a standard deviation of 16.81%. This is much better than companies that do not change dividend policy, pay a dividend, or cut or eliminate a dividend, as seen in the table below.

Dividend Provide Protection in Downmarket

Another reason why dividends matter to investors is that it provides downside protection during a declining market. This fact has been shown in a scientific study by two authors. They concluded that dividend-paying stocks outperform stocks that do not pay dividends by 1% to 2% per month in declining markets than in advancing markets. Their results were statistically significant. They also found that dividend increases matter more in declining markets than in advancing markets.

The presence of the dividend, though, and not the dividend yield itself, drive returns in declining markets. In addition, dividend stocks outperformed those that do not pay a dividend in both the dot-com and sub-prime mortgage crisis. So, this is the fourth benefit of dividends.

Qualified Dividends are Taxed at a Lower Rate

A significant advantage or benefit of dividend investing is that qualified dividends are taxed at a lower rate than your regular income. You can see in the table above that the differences in tax rates for high-income earners can be considerable. It is for this reason that dividend investing strategies are probably prevalent now.

For example, if you have a $1 million portfolio and generate $30,000 in qualified dividends, a single filer’s tax rate was 0% in 2019. However, that same $30,000 in a regular salary is taxed at 12% or $3,600. That’s a pretty big difference.

Final Thoughts on Why Dividends Matter for Investors

You can see that dividends matter for small investors. Dividends have several benefits for investors, and that has been known back for hundreds of years. First, dividends can be a significant component of total return. This fact has been shown in the backtesting of different categories of stocks. Dividends provide income. Dividends also provide downside protection in a declining market, which has been shown in published research. Finally, dividends are also an indicator of the financial health of a company. Overall, there should be no doubt that dividends matter and are a benefit to small investors.

Disclosure: Long KO and COST.

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