Forget Dividends -- Look for These Value Signals Instead

posted on 06-07-2019

For investors, dividends can be a real blessing. Along with interest received from bonds and CDs, the payouts from dividend-paying companies can form a steady income stream.

Simply put, dividends are a distribution of corporate earnings to shareholders. By reinvesting dividend checks (instead of cashing them), stockholders can buy more shares, which leads to even larger dividend checks. These larger checks can then be used to buy even more shares, and so on. In time, even a small stake in such dividend paying stocks can grow into a tidy sum thanks to the magic of compounding.

Companies that offer dividends are essentially saying, "Our business is so strong and profitable that we have more money than we know what to do with." And companies that offer dividends are attractive to investors -- there have been many cases of a company's stock price falling amid talks of cutting dividends, showing that a stable dividend payout is integral to a company's financial well-being.

Yet for all of their benefits and allure for investors, there are plenty of good reasons why a company would choose not to pay a dividend. And in some cases, not paying a dividend can send a stronger message than paying one. Not paying a divided can signal that a company is focused on building shareholder value by:

Retaining funds to build the business. On the path to maturity, companies come across many planned and unplanned expenses. Perhaps a new product launch will require lots of investments. Or maybe the company doesn't yet trust that it can remain profitable when the economy turns south. Funds that are used to support a dividend are funds that are no longer available for future needs.

Buying back stock instead of issuing dividends. Some companies prefer to reward shareholders indirectly by shrinking the number of shares outstanding. Teen retailer Aeropostale (NYSE: ARO) has been steadily buying back stock, and its share count has dropped from 120 million to 90 million over the last five years. A smaller share count for Aeropostale means that earnings -- on a per-share basis-- are 25% higher than they would have otherwise been, all other things being equal.

Waiting for more favorable tax treatment. Some companies understand that dividends can trigger unexpected tax consequences for investors because dividends are taxed at the capital gains rate. Moreover, collecting taxes on money that has already been taxed as corporate profits creates the dreaded and hated double taxation. This issue may be of even greater concern in the future -- Washington may look to boost the capital gains tax rate to help close the budget deficit.

Investing in research and development. Apple, Inc. (Nasdaq: AAPL) has a long-standing tradition of eschewing dividend payouts in favor of reinvesting in R&D for new products and technologies. Apple's large stash of cash (roughly $10.7 billion as of year-end 2010) makes it easier to acquire new companies or technologies, without putting the company at risk by taking out loans for these acquisitions. As Apple's CEO, Steve Jobs, puts it, "We know if we need to acquire something -- a piece of the puzzle to make something big and bold -- we can write a check for it and not borrow a lot of money and put our whole company at risk…The cash in the bank gives us tremendous security and flexibility."

Paltry Dividends -- Why Even Bother?

If a company is going to issue a dividend, it should be substantial enough to provide meaningful income streams for investors. New York-based utility Con Edison (NYSE: ED) will pay out $4,800 in annual dividends for every $100,000 you invest. That 4.8% dividend yield is impressive and in-line with what many dividend paying stocks have historically yielded.

#-ad_banner_2-#Dividends are certainly appreciated by income-focused investors -- especially if those dividends are large enough to create a solid source of income. But in many instances, especially when the dividend is marginal, you should be wary.

For example, some companies offer up paltry dividends as some sort of token gesture. Technology firm Cisco Systems (Nasdaq: CSCO) recently began a dividend paying program, offering a $0.24 annual dividend. That works out to a 1.3% dividend yield. $100,000 invested in Cisco will get you roughly one-fourth the payout invested in Con Edison. Why bother? Cisco's desperation to attract investors is directly related to its poor stock performance of late.

But one of the most common reasons management declares a dividend may actually be the biggest destroyer of shareholders value. It's well-known in the finance world that a solid dividend (and solid dividend yield) will protect share prices from falling sharply in a bear market. Any drop in the share price automatically pushes up the yield, thus attracting a new round of investors. But in a case like this (as we experienced in 2009), a large stock buyback may actually be a better use of company cash than issuing a juicy dividend. Here's why.

After a big drop in stock price, a larger number of shares can be reacquired by the company for a fixed dollar amount. Case in point -- when home improvement retailer Home Depot (NYSE: HD) was faced with a tough housing market starting in 2007, its shares fell from $40 to below $20 by early 2009. Spotting an opportunity, management stood by an ongoing share-buyback program and was able to buy more shares for the same pre-committed amount of money. The company bought back more than 200 million shares, reducing the share count by more than 10%. In fact, shares outstanding has fallen from 2.3 billion in fiscal 2004 to 1.65 billion in fiscal 2011.

So, while a monthly or quarterly dividend payout would be nice for investors, sometimes it's better to see these funds applied to something other than a dividend payment. And in return, investors can be rewarded by the continued increase of the company's stock.