The Importance of Dividends

Dividends are very important to the investor. Every young investment student learns of the "greater fool theory" when their professor or mentor asks whether dividends are important. If the answer is "not really, if the share price increases", the professor then goes on to explain that without eventual dividends to the investor, the share is worthless. Consider, in the extreme, the purchase of a share that guaranteed not to pay any dividends or other payouts to the holder. What would be the worth of this share to the holder? Simply, it would be a "promise not to pay". Ever. The holder might get some psychographic thrill from saying they owned the share, but they would in reality have the same claim to its assets and cashflows as anyone else. Their claim would be worthless, except if they sold it to someone who hadn't figured this out. Hence the "greater fool theory".

The annualized dividend divided by the market price of a common share is called the "dividend yield" and forms an important component of the valuation process. Even though many companies don't pay dividends, they have the potential to pay dividends in the future. If they invest their earnings in new assets which will earn future cashflows, we have a claim on these future cashflows. This is why many "growth companies" in an expanding phase don't pay dividends. The shareholders hope the company reinvests their share of profits at a high return. If the company fails to make profits on these reinvestments, they would be better to pay out the profits as dividends to shareholders who could do a better job of reinvestment on their own.

Long term studies have shown that reinvested dividends are very important to the returns that investors make. They form a very important component in securities valuation and should have a very important place in the investor's analysis of a company. Well managed and excellent companies like General Electric have a history of increasing dividends. An investor should be very wary of a company that doesn't seem to want to pay dividends. If the analysis shows the earnings are reinvested in profitable projects rather than paid in dividends, this is a very good thing. If the analysis shows the projects are unprofitable or that excessive corporate expenses have eaten up the potential dividends, this is a very bad sign. Absence of a corporate dividend with stories of the corporate jet flying the President's poodle around the globe should not be taken lightly.

High dividends is not always a sign of good management. A company that needs to reinvest should not pay out all of its accounting profits in dividends. This will cause the productive capacity of the company to diminish and the company to eventually fall into bankruptcy. This actually is a technique of "corporate vultures". They buy a large controlling position in a fine company and purposefully pay far more dividends than they should. This causes the competitive position and productive capacity of the company to falter. This all takes a long time to happen and the company can rest on its laurels for a while. It takes outside analysts a long time to figure all this out. Accounting rules offer lots of scope to obscure what's going on The company is usually able to borrow money to pay dividends for quite a while before the market refuses to offer more credit. Then the inevitable day