If you've made it this far through our Learning Centre lessons, you can't have escaped the following: A share represents an ownership in a business. So let's say we are part owners as well as managers of a business, and when we closed the books on the year, our firm made a £10 million profit. Better yet, we collected all of it in cash. Now the rub--what to do with that cash?
Assuming we don't simply leave it in the corporate cheque book (though some companies certainly do), we've got four choices. We could:
1. Reinvest it in the business;
2. Acquire another company;
3. Pay down debt;
4. Return the cash to shareholders.
Real-life boards of directors face this decision in every quarter of every year. While the first three options can be productive uses for cash, the fourth--a reward to shareholders--is a critical part of the investment process. After all, why else would you want to own a stock if you never received a payback on your investment? Stocks are perpetual-life securities--there's no guaranteed payoff at some maturity date like there is with a bond.
In fact, the grandfather of security valuation (a little-known figure named John Burr Williams) defined a stock's value as the present value of future dividends. It's pretty easy to see why this is true. Even though capital gains loom large in most investors' minds, the ability to sell a stock tomorrow for more than was paid today is contingent on that stock eventually returning cash to its owner, whoever that owner might be at the time.
Dividends and taxes
The two components to total return--dividends and capital gains--have
two totally different tax treatments. Dividends are immediately taxable.
Taxes on capital gains, on the other hand, aren't due until the stock is
sold, creating a tax deferral that aids in wealth accumulation. In
theory, if the dividend hadn't been declared, the value of that payment
would have continued to compound tax-deferred within the company.
You pay tax at different rates on UK dividends than you do on other income such as wages and tax rates have a tendency to change year by year so keep up to date with the help of the UK government's web site.
When you receive your dividend you get a voucher that shows the dividend paid--the amount you received--and the amount of associated 'tax credit'. Companies pay you dividends out of profits on which they have already paid--or are due to pay--tax so the tax credit takes account of this and is available to the shareholder to offset against any income tax that may be due on their dividend income.
When adding up your overall taxable income you need to include the sum of the dividends received and the tax credits. This income is called your 'dividend income'.
Dividends and total returns
During the bull market, the pursuit of rapidly growing businesses
obscured the real nature of equity returns. But growth isn't all there
is to successful investing; it's just one piece of a larger puzzle.
Total return includes not only price appreciation, but income as well. And what causes price appreciation? In strictly theoretical terms, there's only one answer: anticipated dividends. Earnings are just a proxy for dividend-paying power. And dividend potential is not solely driven by growth of the underlying business--in fact, rapid growth in certain capital-intensive businesses can actually be a drag on dividend prospects.
Investors who focus only on sales or earnings growth--or even just the appreciation of the stock price--stand to miss the big picture. In fact, a company that isn't paying a healthy dividend may be setting its shareholders up for an unfortunate fate.
In Jeremy Siegel's The Future for Investors, the market's top professor analysed the returns of America’s original S&P 500 companies from the formation of the index in 1957 through to the end of 2003. What was the best-performing stock? Was it in colour televisions (remember Zenith)? Telecommunications (AT&T)? Groundbreaking pharmaceuticals (Roche)? Surely, it must have been a computer stock (IBM)?
None of the above. The best of the best hails not from a hot, rapidly growing industry, but instead from a field that was actually surrendering customers the entire time: cigarette maker Philip Morris, now known as Altria. Over Siegel's 46-year time frame, Philip Morris posted total returns of an incredible 19.75% per year.
What was the secret? Credit a one-two punch of high dividends and profitable, moat-protected growth. Philip Morris made some acquisitions over the years, which were generally successful--but the overwhelming majority of its free cash flow was paid out as dividends or used to repurchase shares. As Marlboro gained market share and raised prices, Philip Morris grew the core business at a decent (if uninspiring) rate over the years. But what if the company--listening to the fans of growth and the foes of taxes--attempted to grow the entire business at 19.75% per year? At that rate it would have subsumed the entire US economy by now.
The lesson is that no business can grow faster than the economy indefinitely, but that lack of growth doesn't cap investor returns. Amazingly, by maximising boring old dividends and share buybacks, a low-growth business can turn out to be the highest total return investment of all time. As Siegel makes abundantly clear, "growth does not equal return." Only profitable growth--in businesses protected by an economic moat--can do that.
DRIPs
If you think dividend-paying stocks might be good for you, you may want
to consider participating in a DRIP. DRIP is common shorthand for
"dividend reinvestment plan." Not every investor needs dividends for
income, so many dividend-paying companies offer the option of
automatically reinvesting dividends in additional shares.
Signing up for DRIPs may help you focus on a company's long-term business prospects (because you will presumably participate in a DRIP for a long time), and it also allows investors to benefit from pound-cost averaging. Many plans even offer a discount to the market price of the shares on the payment date.
You can find out more about a company's DRIP by visiting the investor relations section of its web site. Participating in a company's DRIP requires having the shares registered in your name (rather than "street name," where your broker is listed as the owner on your behalf), but before starting the paperwork to retitle your stock holdings, you'll want to find out if your broker offers a low-cost or free dividend reinvestment option as well--many of the larger firms do.
The bottom line
Traditional-minded investors like us are glad to see dividends making a
comeback. Compared with retained earnings or buybacks, a solid dividend
establishes a firm intrinsic value for the stock, helps reduce the
stock's volatility, and acts as a check on management's
capital-allocation practices. Simply put, it's the way things were meant
to be.
For more investing classroom lessons on equities, bonds, funds and portfolio management, check out our Learning Centre.
