Searching for Yield

Investment Basics (6): Searching for Yield

Way back at the beginning of the fifteenth century the Dutch East India company was formed to represent Dutch trading interests in the East. Uniquely this company didn’t require itself to be wound up in order to pay out its profits, instead it would split them between the company’s shareholders and pay them out as a dividend . Suddenly companies could be valued on the basis of a long term earnings stream, rather than as pots of capital.

For many investors the dividend is the equivalent of interest on a savings account and the yield – the interest rate – is calculated by dividing the dividend per share by the share price. So if the shares are priced at $40 and they pay a dividend of $2 per share per year then the dividend yield is 5%. Dividends are, however, never the only basis upon which to base an investment.

Dividends and Earnings

As we’ve previously established companies make profits which constitute their earnings. The directors of a company have many choices as to how they spend those earnings. One choice is to re-invest it back in the company – to hire more sales people, to engage in more product research and development, to takeover other businesses, to buy back their own shares, or, for the Dutch East India Company, to launch more voyages of discovery. The main aim of such activities is to increase future earnings – so, for instance, if you employ more sales people you expect to make more sales and therefore future earnings are higher. As earnings and share price are connected then an increase in earnings will, all other things being equal, see the share price go up.

However, like the East India Company, the directors may also decide to pay out some of the earnings to shareholders in the form of dividends. As many investors, institutional and private, buy shares on the basis of the dividend yield as an alternative to “safe” investments like bonds or savings accounts this can attract a loyal base of shareholders which makes the company less likely to be taken over or for its share price to oscillate wildly. Well, a bit less likely.

Generally you’d expect a company that retains all of its earnings to grow its market capitalisation more quickly than one that pays out dividends. Sadly, though, this isn’t usually what happens and, by and large, companies that reinvest earnings in their businesses underperform (in share price terms) those that pay reasonable dividends in the long term. This is plainly nuts and needs some attempt at explanation.

Value Shares and Growth Shares

In this series we’ve already discussed the difference between Value and Growth stocks. Usually you should expect Value stocks to pay higher dividends than Growth stocks. Many Growth stocks will pay no dividend at all. The reason for this is simple – Growth stocks offer more opportunities to expand the basic business and increase earnings rapidly, so it makes sense to reinvest earnings in the business. Value stocks tend to be mature businesses which have established franchises but which find it difficult to produce stellar earnings growth. These companies often throw off cash that they can’t use in the business so they return it to shareholders in the form of dividends.

So it may seem obvious that one should invest in Growth stocks over Value stocks. If Growth stocks grow more quickly then they’ll compound your investments faster and make you more money. Which is true if, and only if, two things are true. Firstly your Growth stock has got to be successful and secondly you’ve got to fritter your dividends away on pointless consumables like food and stuff.

Growth v Value

Remarkably research shows that investors who buy Value stocks and reinvest their dividends in other Value stocks outperform those who purchase Growth stocks and hold them. The reason for this is primarily that most Growth stocks are small, risky and the majority fail to meet their initial promise. The chances of picking the next Microsoft or Google are vanishingly small. Moreover, the chances of holding the next Microsoft or Google from tiny small cap to world dominating business are even more microscopic.

Value stocks, on the whole, tend to be fairly mature businesses that grow relatively slowly but relatively safely. If investors take the dividends from these and invest them in other Value stocks the overall effect is to increase each investors’ earnings – which, really, should be the measure most investors are concerned about. However, if investors spend their dividends on frivilous consumables instead of reinvesting them this advantage is lost: and there are many long periods over which dividends constitute the only growth in the stockmarket, as share prices can go sideways in real terms for decades at a time.

Dividend Cover

Despite this it’s a fact that dividends alone do not a good investment make. One useful measure to consider is dividend cover. This metric shows you what percentage of earnings is being paid out as dividends (as measured by earnings per share divided by dividend per share).

If a company is paying out all of its earnings in dividends then the dividend cover would equal 1. If it’s paying out more in dividends than in earnings then the dividend cover would be less than 1. This does happen occasionally, usually where the company argues that earnings will increase sharply in future and while it has enough money in the bank to afford the “uncovered” dividend.

Because dividend paying companies tend to be assessed on the stability of the dividend – which should increase steadily over time – then a cut in the dividend can see the share price drop dramatically. It therefore pays to be wary of companies with low dividend cover. Unless the business has a very stable earnings stream then a dividend cover of less than 1.5 is suspect and some would insist on levels of up to 2.

However, if a company is not paying out all of its earnings in dividends that begs the question of what it is doing with them. Reinvesting the extra money in the business, generally, although that’s often a double edged sword.

Reinvesting Earnings

Executives with a pot of retained earnings frequently suffer from an uncontrollable urge to go out and spend it, often on themselves. Leaving it sitting in an interest bearing account isn’t very interesting and, frankly, that’s something the shareholders could do for themselves. So there’s a pressure on executives to find a use for retained earnings.

Companies that can reinvest earnings to achieve greater earnings growth are, sadly, quite rare. Executives tend to spend earnings on executive perks like swivel chairs, company jets, salary rises and wasteful acquisitions. Mostly these activities fail to enhance earnings in any appreciable way – and often have exactly the opposite effect.

The great success of Berkshire Hathaway has been mainly because it has been brilliant at reinvesting retained earnings – and it retains them all, paying no dividends. Warren Buffett’s great skill is not in management but in allocating capital to new businesses which provide Berkshire with additional, growing earnings streams. Think of him as a private investor taking dividends from his portfolio of stocks and reinvesting them in new companies that provide above average earnings. It sounds simple, but it’s darned difficult.

Earnings Yield

Obviously then, dividends shouldn’t be the only way to assess the worthiness of a company as an investment. One alternative measure is the earnings yield which is the earnings per share divided by the share price. The beauty of this metric is that it shows you how much excess earnings your investments are throwing off. Profits are the proper measure of a company, not dividends and a high earnings yield indicates the company is highly profitable compared to alternative investments.

So to analyse a company properly you really need to look at its earnings, assess how stable these are and look at how it spends them. Dividends should be an important part of this analysis because growth companies go wrong too often to be suitable for most private investors. There are exceptions to the non-dividend paying “rule”, but not many.

You also need to look at the company’s costs to try and assess how stable these are. It’s no good investing in a company that’s steadily growing its earnings if it’s costs are about to go through the roof. Next time out we’ll look a bit more closely at the cost side of the balance sheet.

Main Points:

1. The dividend yield of a company is the dividend per share divided by the share price.
2. A dividend is cash returned to shareholders.
3. Dividends are paid out of a company’s earnings.
4. Any earnings not paid out as dividends are said to be retained.
5. Retained earnings should be spent to enhance future earnings growth.
6. All things being equal a company paying out a sustainable dividend is a better investment than one that pays no dividend.
7. The sustainability of a dividend can be assessed by looking at the dividend cover – cover of less than 1.5 should cause an investor to look more closely at how reliable the dividend is.
8. The earnings yield of a company allows you to compare relative earnings between companies – a high earnings yield indicates high profitability.
9. The earnings yield is the earnings per share divided by the share price.
10. The sustainability of earnings needs to be crosschecked by looking at how stable future earnings are.
11. Sustainability of earnings also depends on whether costs are under control – if these are likely to rise sharply in future then the earnings will be under threat.


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