Should The Company Pay A Dividend?

Common Stock Dividends
There are 2 ways that investors can earn a profit by buying stock: by buying the stock low and selling it higher, and by receiving dividends. While most companies—especially small, growing companies—do not pay a dividend, most large, profitable companies do by necessity, because there is a limit to how large a company can grow, and so the only way to maintain its stock price is by paying a dividend.


However, there are several advantages to stocks paying a dividend over those that don’t. Dividend-paying stocks provide a more certain income than what price appreciation alone offers. When the stock market declines, holders of dividend-paying stocks still receive an income, and the dividend helps to maintain the stock price even in a down market. And, often, the dividend plus the capital gains of a dividend-paying stock is greater than the capital gains of many stocks that do not pay a dividend. In fact, dividends have accounted for about 40% of the total return of the stock market since 1928!

Should The Company Pay A Dividend?

Whether a dividend will be paid depends on the profitability of the firm. While a firm does not have to earn profits to pay a dividend, it would generally be a bad decision for an unprofitable firm to pay dividends. And without profits, the future payment of a dividend would be in jeopardy.

The board of directors decides if and when a stock dividend will be paid, and how much. The board will generally consider the company’s financial position, both now and in the future, and the opportunity costs of paying a dividend. If the company can use the money to grow faster, then a dividend probably will not be paid. But if a company is both large and profitable, then it could pay some portion of its earnings as a dividend, since it becomes more difficult for a large company to grow ever larger. Hence, without the payment of a dividend, investors will shun the stock, since there is little chance to profit from price appreciation, and the stock’s price will collapse.

Besides size, the largest factor in considering a dividend payment is the company’s common earnings per share (EPS), which is the after-tax income of the company minus the dividends paid to preferred shareholders divided by the number of common shares outstanding.

Earnings Per Share = (Net Profit – Preferred Dividends) / Number of Outstanding Common Stock Shares

If the common earnings per share is high and likely to remain high, and if the company is too large to grow much larger, then the board of directors will probably decide to pay a dividend.

The Dogs Of The Dow Strategy - The Results

The following table presents the total returns for various calendar years and the average of annual total returns for the one, three, five, 10, and 19-year periods ending December 31, 2010.

All total returns are calculated using reinvested dividends, and all data is in %.

Investment		2004	2005	2006	2007	2008	2009	2010		1 Year	3 Year	5 Year	10 Year
Dogs of the Dow		4.8	-5.1	30.3	2.2	-38.8	16.9	20.5		20.5	-0.5	6.2	4.6
Small Dogs of the Dow		13.2	-0.4	42.0	4.2	-49.1	10.2	26.7		26.7	-4.1	6.8	5.7
Dow Jones Industrial Average		5.3	1.7	19.1	8.9	-31.9	22.7	14.1		14.1	1.6	6.5	4.8
S&P 500		10.9	4.9	15.8	5.5	-37.0	26.5	15.1		15.1	1.5	5.2	3.6
Fidelity Magellan		7.5	6.4	7.2	18.8	-49.4	41.1	12.4		12.4	1.4	6.0	3.3
Vanguard Index 500		10.7	4.8	15.6	5.4	-37.0	26.5	14.9		14.9	1.5	5.1	3.5

The Dogs Of The Dow Strategy

The Dogs of the Dow is a fairly simple investment strategy. It was proposed by Michael O'Higgins in the early 1990's and it basically says take the 10 stocks with the highest dividend yields and buy them for next year because those stocks should outperform.

So you should pick the 10 highest yield shares in the Dow Jones Industrial Average and put an equal amount of money into each of them. Adjust the portfolio once a year so that it once again has equal amounts in the top ten shares by yield.

The strategy has become so popular that there are even two special Dow Jones indices (the Dow 5 and the Dow 10) that track the performance of Dogs of the Dow type strategies.

The track record of this type of value investing is fairly good, and it is certainly a strategy worth considering.

It also has the advantage of requiring a portfolio re-balancing only once a year which means that trading costs are low. Using an execution only broker who charges a flat rate per trade, the maximum possible commission paid per year is just twenty times the commission per trade. It is likely to be much lower.

HOW HAVE DOGS OF THE DOW STOCKS PERFORMED LATELY:

- During the tech bubble of the late 90s, the high dividend stocks of the Dogs of the Dow were up 28.6% in 1996, up 22.2% in 1997, up 10.7% in 1998, and up 4.0% in 1999.

- During the difficult bear market years of 2000 - 2002, the Dogs of the Dow were up 6.4% in 2000, down 4.9% in 2001, and down 8.9% in 2002, and that was enough to significantly outperform the Dow, S&P 500, and Nasdaq.

- In 2003, the high dividend stocks of the Dogs of the Dow gained 28.7% and made new, all-time highs despite the massive bear market of 2000-2002!

- In 2004, the high dividend yield Dogs of the Dow remained in record territory with a 4.4% gain and then gave back 5.1% in 2005.

- In 2006, the Dogs of the Dow surged to new record highs with a gain of 30.3%. The Small Dogs of the Dow did even better with a gain of 42%!

- In 2007, the Dogs of the Dow and the Small Dogs of the Dow were flat but declined in 2008 along with the rest of the market as the financial crisis unfolded.

- In 2009, the Dogs of the Dow rebounded with a 16.9% gain.

- In 2010, the Dogs of the Dow significantly outpaced the Dow with a gain of 20.5%. The Small Dogs of the Dow did even better with a gain of 26.7%!

Stock Buybacks: What Is It And Why It's Done?

What Do We Mean By Stock Or Share Buybacks?

A stock buyback, also known as a "share repurchase", is a company's buying back its shares from the general public. We already know two most common ways in which company return value to the shareholders, and these are stock appreciation and dividends. The third one is stock buyback. When company buy its own shares, because it can not act as its own shareholder, these shares are owned by the company and the number of shares outstanding is reduced by that amount. As a result, every shareholder of the company now has larger % share in the company, and also has a larger EPS or earnings per share (we'll talk about meaning of that in later posts).

Why Would Company Buyback It's Own Shares?

When company make profit, it has two options: pay that money to its shareholders or reinvest it in the business. Usually, company do both, pay some dividend and keep rest of the profit as a retain earnings. But, there are times when management of a company do not see good opportunity to invest, or their main business is non worth investing in. Example is Berkshire Hathaway company. Their chairman, now investment legend Warren Buffett, used companies profits and cash flow from textile business to acquire shares in other companies, because he realized that textile industry was with low profit margins and that that had strong competition from China.

1st. Reason:

So when there are no other better options to put money to good use, last option is share repurchase or stock buyback. When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of shares held by the public (also known as a float) means that even if profits are the same, earnings per share will increase. Also, if company's share price is undervalued or depressed, share buybacks will improve return on investments.

2nd. Reason:

Other aspect of stock repurchases is this: if a company's management see that it's stock price is low, or that it is lower than actual book value (more about that in future posts) and currently trading below its intrinsic value, they will consider repurchases.

 3rd. Reason:

Another reason why management prefer share buybacks is that because their compensation is often tied to their ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. It is important to understand that increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value.

4th. Reason:

Share repurchases avoid the accumulation of excessive amounts of cash in the corporation, because companies with strong cash generation will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition (also known as Leveraged buybacks - LBO). Anti-takeover strategies therefore often include maintaining a low cash position and the share repurchases increase stock price which makes a takeover more expensive.

5th. Reason:

Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with double taxation.

In latter post I'll cover pros and cons of stock buybacks.

Is Stock Split Beneficial For The Investors?

Do Companies With Splitted Stocks Outperform Similar, Non-Splitted Ones?

On the surface, a stock split is nothing more than accounting transaction, it leaves investors no better or worse off. That is the reason why critics argue that a stock split is a non-event. They're convinced that a split is simply an accounting function with no relationship to stock performance. In fact, they think investors are foolish to believe there is any money to made from something as unimportant as a stock split.

On the other hand, companies argue that by reducing per share prices, stock splits make shares more attractive to individual investors. And splitters often claim that a higher share count allows for more trading liquidity and greater institutional ownership. Finally, some investors argue that stock splits are bullish because of the positive signal they send about a company’s prospects.

Most traders view stock splits as high potential trading opportunities. They consider splits a positive progression in value and goodwill for companies and their investors. Corporate executives use stock splits as marketing and investor relation tools. They know that stock splits make shareholders feel better and engender a sense of greater wealth.

What Academic Researches Tells Us?

One study supports the belief that stock splits help attract new investors and improve liquidity. More important, research suggests that stocks tend to outperform after split announcements.

For many years, academics argued that stock splits should be a poor predictor of stock-market returns. The position was easily defended, because stock splits do not increase a company’s intrinsic value. If you hold 1000 shares of a stock that trades for $100 a share, your position is worth $100,000. After that stock splits 2-for-1, you hold 2000 shares valued at $50 apiece, also worth $100,000.

Some studies using price data from the 1920s through the 1970s,  suggested that stock splits have little effect on future price movements. But a number of studies in the 1980s and 1990s show that stocks tend to outperform after they announce a split, despite the fact that prices had often risen sharply before the announcement.

One study of 2-for-1 stock splits between 1975 and 1990 found companies that split their stock outperformed companies of similar size by an average of 7.9% in the year after the split and 12.2% in the three years after the split.

Another study, between 1988 and 1997,  found that shares of companies that split their stock outperformed stocks of similar size, type such as value or growth and liquidity by an average of nearly 9.0% in the year after the split. Other studies showed that that stock splits increase trading costs because of higher bid-ask spreads, which translate into more profits for market makers on the stock exchange and less money to investor.

While stock prices tend to rise in the days after the split announcement, much of the excess return occurs later. One study found that stock prices outperformed by an average of 3.4% in the five days after the split announcement, then another 4.5% over the next 51 weeks of trading.

The relationship between stock-split announcement and price gains appears to continue today. The Forecasts looked at more than 700 stock-split announcements between August 2000 and July 2004 and determined that, on average, splitters outperformed the S&P 500 Index by 9.7% and 14.7%, respectively, in the six and 12 months after the announcement. More than 64% of the stocks beat the market during those periods. On average, only 3% of the out performance occurred during the five days after the announcement.

A 1996 study by David Ikenberry of Rice University measured the short and long-term performance of stock splits. His research included all the 1,275 companies whose stock split 2-for-1 between 1975 and 1990. Ikenberry compared the split stocks to a control group of stocks for similar-sized companies in similar sectors that had not split. His results were startling. The split stock group performed 8% better than the control group after one year, and 16% better after three years.

In August 2003, Ikenberry updated the stock split study. This time he looked at companies from 1990 to 1997. Using a similar methodology that included 2-for-1, 3-for-1 and 4-for-1 stock splits, he found the results were the same. Shares of split stocks on average outperformed the market by 8% the following year and 12% over the next three years.

 

Reasons Why Stock Splits Increase Profits For Investors:
 
1. The stock split announcement draws attention to a company's success. This results in increased buying and higher prices. 
2. Companies will often report high earnings and raise dividends at the same time they announce a stock split. The synergy of these events can drives the price of the stock up even more. 
3. The reduced price per share after companies split a stock attracts many smaller investors. 
4. With so many news and information services reporting stock splits, the announcements themselves have become a market-moving force. 

Whatever side you take, my advice is not to buy a stock solely based on a split!

More About Dividends

What Are Two Main Types Of Dividend Policies?

Cash dividends,  are those paid out in currency. This is the most common method of sharing corporate profits with the shareholders of the company.They are form of investment income and are usually taxable to the recipient in the year they are paid. For each share owned, a declared amount of money is distributed. So if an investor owns 100 shares and the cash dividend is $1.50 per share, the holder of the stock will be paid $150.

 
Stock or scrip dividends are paid out in the form of additional stock shares of the issuing corporation instead of paying in cash.They are usually issued in proportion to shares owned (pro-rata). If the payment involves the issue of new shares, it’s same as stock splits, which will cover later, in that it increases the total number of shares while lowering the price of each share without changing the market capitalization of a company.

Ratios Commonly Used To Gauge The Sustainability Of A Firm's Dividend Policy: Dividend Cover And Payout Ratio:

 
Dividend cover of a company is important factor to understand about an investment, and see if a company has a stable payment policy. Do they increase their payments in an orderly and regular way, are payments made at a constant rate and will the firm be able to maintain these payments? 

 
One measure used to help answer these questions is a ratio known as dividend cover:

 
Dividend Cover = Earnings Per Share divided by Dividend Per Share

 
The inverse of this ratio is the proportion of earnings that belong to ordinary shareholders which are distributed to them, better known as the dividend payout ratio. If a company has a dividend cover ratio of 1.0, it pays out all earnings in dividends. This means that should earnings fall, the company might be forced to cut annual dividend payments. 

 
Many firms use annual dividend payments as a signal to shareholders and the market of confidence, so in the short term, directors will be reluctant to reduce payments, unless the firm is in trouble.


How Is Dividend Yield Calculated?

Dividend yield is used for comparing the relative attractiveness of various income stocks, or stocks that pay dividend. It tells you, in a percentage terms, what you can expect to profit in a year if you buy that stock. It is useful because it allows us to compare it, not only with other stocks, but with other investments such as bonds or certificates of deposit.

 
Formula is: Dividend yield =  Annual dividend / Current stock price. 

 
So if company has a price 20$/share and it pays 2$/share dividend, dividend yield will be: 2$ / 20$ = 10%.

What Is A Dividend?

The word "dividend" comes from the Latin word "dividendum" meaning a thing to be divide. The definition of a dividend as it relates to finance is:

1. A pro-rata share in an amount to be distributed
2. A sum of money paid to shareholders of a corporation out of earnings
 

An investor who is holding common stock ie. ordinary shares in a company will receive a return in one of two ways: capital gains which come from price changes and dividends. They are payments made by a corporation as a portion of corporate profits. When a corporation earns a profit, that money can be re-invested in the business which is called retained earnings , or can be paid to the shareholders as a dividend. Usually, corporations retain a portion of their earnings and pay the remainder as a dividend.
 

There are practical limitations to a company paying out a dividend. A firm must have distributable reserves on the balance sheet to be able to pay a dividend. A company may therefore dip into the undistributed profits of previous years.
 

A firm also must have the cash available to pay out. Any experienced investor will know that profits do not necessarily mean cash, because a company can have last year's profits but negative cash flow, and that means problems to pay dividend to it shareholders.
 

But when company once start to pay dividends, it is difficult for them to stop, because their dividends acctracted some mutual funds that select their investments partly on dividend policy and history of a company, and missing one or more payments can lead to funds selling their holdings. These sales can lead to an imbalance in the supply and demand of stock and a fall in the price in the market.