What I’m about to tell you is pretty shocking to most investors: I don’t like dividends.
I can hear the outrage, but listen to me. Dividends are simply cash left over from a company’s operations and returned to shareholders. Easy enough to understand, right? So what’s wrong with a company paying dividends to its investors?
In theory, there is nothing wrong with companies paying dividends as it is seen as a reward for shareholders. However, there are times when dividends just don’t make sense to some investors.
When a company pays you a dividend, it is essentially sending you the leftover cash that is added to your balance. The unfortunate part of this is that Uncle Sam considers this money to be income, which means you are paying tax on that income.
Now of course you can dodge the helmsman by receiving dividends in a tax-protected account like a Roth IRA. However, in a standard brokerage account, this is what you need to do Pay taxes on your dividends. As a shrewd investor, I want to limit my tax liability as much as possible so that dividends (and bonds) are not tax-friendly assets in your standard brokerage account.
Generally, when a company pays a dividend to investors, management reports it as a fact:
“Our business produces so much cash and we can’t find good ways to reinvest that cash. So we’re just going to give it back to shareholders.”
If you’re reading this statement, it sounds like good management practice, doesn’t it? Yes, it can be good practice … sometimes. In certain cases, the company really has no choice but to distribute dividends as that is going to be the most valuable asset for shareholders at that point.
But I generally don’t like this strategy. As a long-term investor, I would rather reinvest the company all of its receipts into more profitable ventures that will compose the business and hopefully the stock price.
That is exactly what Warren Buffett does as CEO of Berkshire Hathaway. He has never issued a dividend for Berkshire’s stock as he wants to withhold all of the company’s profits so that they can be pieced together with the highest possible return.
For this to be possible, the company’s management must be exceptionally good at what they do. However, this is not a problem as this is the type of management we want to blame for our money anyway!
Are dividend companies all bad investments?
No There are still a few good reasons to buy a stock for its dividend. For me it all depends on the rating. Before we get into the valuation, let’s talk about the characteristics of good dividend stocks that we want to buy.
Characteristics of good dividend stocks
Sustainable and predictable business
If we are to buy a stock for dividend only, we need to be sure that the company will last over the long term. We need to analyze the business and make sure it’s been up and running for at least the next 10 or 20 years.
Staple food manufacturers fit this shape perfectly. Some consumer goods companies have been around for decades or even centuries. Longevity is the key here.
Solid balance sheet
In order for a company to pay a dividend, it must have a solid balance sheet. What we’re really looking for here is to make sure the company doesn’t have any liabilities that would affect dividend payments. A debt-ridden company will be forced to cut its dividend to pay off its loans.
Strong cash flows
To pay a dividend, a company must have strong cash flows. The cash flow from operating activities should be stable and grow annually.
Here’s a dangerous scenario to watch out for: companies borrowing money to pay a dividend. Believe it or not, this is what happens. This is a sign of bad management. We definitely don’t want such companies.
We want to rely on the growth in cash flow from operations (not debt).
In order for dividends to remain valuable to us, the company must increase the dividend every year. These companies are known as Dividends aristocrats and are some of the most famous companies in the market.
A company that is cutting or suspending its dividend is not what we’re looking for. We want to see uninterrupted dividend growth year after year.
We come to the evaluation.
How to rate dividend stocks
Return on cost method
The method I prefer when strictly valuing a company on its dividend is the yield-on-cost method. The return on costs is simply the dividend per share (DPS) over the share price. This is how we calculate our return.
Now when I’m reviewing a dividend stock, I want to see how quickly the company can pay me dividends on the capital invested in the stock. Here’s my rule of thumb when looking for a good dividend stock:
With this method, after ten years in ownership of the stock, the company would have paid me back my original capital that I had invested in the stock. After this time, you can enjoy the capital appreciation of the share price as a bonus.
Let me go over an example of this.
Example for Tyson Foods (TSN)
Before we do any evaluation work, let’s go through Tyson’s basics to see if it is a good fit for you.
Sustainable and predictable business
Here is a snapshot of Tyson’s business model:
Tyson has a broad portfolio of meat and poultry products that are sold to millions of customers. I don’t know about you, but I have to eat every day. While I don’t always eat meat every day, millions of other people do. This is unlikely to change anytime soon, especially as the world population continues to grow.
There’s a good chance you have one of Tyson’s products in your fridge right now. If food isn’t a predictable and stable business, then I don’t know what it is.
Solid balance sheet
For the past decade, Tyson has had a clean balance sheet, with its assets (both overall and short-term) well outperforming liabilities. They maintain a current ratio of 1.8 and a fast ratio of 1.0.
Strong cash flows
Tyson has seen significant cash flow growth over the past decade. Cash flow from operating activities and free cash flow continue to increase each year while investments are kept in check.
Because of Tyson’s outstanding track record, they have been able to steadily increase their dividend each year. In fact, Tyson’s dividend has posted a CAGR of over 26% over the past decade, up from $ 0.12 per share to $ 1.71 per share.
Now let’s get to the fun part: evaluation. We only need a few entries to calculate the return on costs.
The key inputs here are the expected dividend growth rates that you expect.
Tyson has had excellent dividend growth over the past decade, but dividend growth has slowed in recent years, likely due to COVID-19 pressures. To have a margin of safety, I estimated that the dividend would increase by 15% in the first ten years and to 10% in the next ten years thereafter.
Here are our results:
So if we buy TSN at its current share price of $ 76.75, we can see that we will get a 100% return on costs by year 15. This means Tyson will keep increasing its dividend by year 15 as we expect, the dividend paid off on our stock purchase of $ 76.75, and you can enjoy all of the dividends and capital appreciation in the stock for free from then on.
Now 15 years is a pretty long wait. Here time is on your side. All you have to do is make sure you are buying at a reasonable price so that the value makes sense.
As I mentioned earlier, I shoot to get a 100% ROI in around ten years. This gives me ample time to enjoy the “free” dividends and capital appreciation of the stock price for decades to come.
Try it again
Unfortunately, Tyson did not meet my expectations of giving me a 100% ROI in ten years’ time. For example, suppose Tyson’s stock price falls to $ 50 tomorrow. If everything else is the same, the dividend would now be 3.4%.
Here you can really see how the compounding takes place. By the 12th year we have had a return on costs of over 100%. If we hold on to the next 10 years, our ROI will be over 300% by year 20!
This also does not even take into account the regular capital growth in the share price during this period. Your real returns would probably be even better.
If you think it might not be possible, TSN’s stock price has fallen not just once but twice to nearly $ 50 in the past three years.
Now all the talk about dividends and compounding sounds really cool, and it is. But the most important thing is that you have to buy such offers when the going gets tough. Over a year ago when we saw the COVID crash, no one wanted to buy a stock like TSN, which may have offered them a solid return on costs.
That’s what Real Value Investing is all about: Simply buying wonderful companies at bargain prices.
After all the talk about dividends, why don’t I like her? To put it simply, dividends are great if you want / need the money now. This is why so many retirees hold dividend stocks, and as we’ve seen, it makes sense when you’ve had decades to earn dividends.
On a regular taxable investment account, I would have to pay tax on the dividends I receive. However, this strategy could work to your advantage if properly invested in a tax-privileged account.
But for me, my investment doesn’t have to be cash at this point. I prefer to invest my capital in a company that will put the business together with an even higher return (through share buybacks or capital appreciation of the stock) without ever receiving a dividend.
Even so, I keep looking for good deals like these that come up from time to time. But in a foamy stock market with high asset prices, I’m more likely to buy good quality stocks at fair prices than decent stocks at bargain prices.