Just as the impact of dividends on total return on investment, or ROI, is often overlooked by investors, so too is the fact that dividends provide a helpful point of analysis in equity evaluation and stock selection.
Evaluation of stocks using dividends is often a more reliable equity evaluation measure than many other more commonly used metrics such as the price-to-earnings, or P/E ratio.
Most financial metrics used by analysts and investors in stock analysis are dependent on figures obtained from companies’ financial statements.
The potential problem with evaluating stocks solely based on a company’s financial statements is companies can, and unfortunately sometimes do manipulate their financial statements through accounting practices to improve their appearance to investors.
Shares, however, offer a solid indication of whether a company is performing well. In short, a company has to have real cash flow to make a dividend payment.
Examining a company’s current and historical surplus payout gives investors a firm reference point in basic fundamental analysis of the strength of a company.
Dividends provide continuous, year-to-year indications of a company’s growth and profitability, outside of whatever up-and-down movements may occur in the company’s stock price over the course of a year.
A company consistently increasing its dividend payments over time is a clear indication of a company that is steadily generating profits and is less likely to have its basic financial health threatened by temporary market or economic downturns.
An additional benefit of using dividends in evaluating a company is that since dividends only change once a year, they provide a much more stable point of analysis than metrics that are subject to the day-to-day fluctuations in stock price.
Reducing Risk and Volatility: Dividends are a major factor in reducing overall portfolio risk and volatility. In terms of reducing risk, dividend payments mitigate any losses that occur from a decline in stock price.
But the risk reduction benefit of dividends goes beyond that basic fact. Studies have consistently shown that dividend-paying stocks significantly outperform non-dividend-paying stocks during bear market periods.
While an overall down market generally drags down stocks across the board, dividend-paying stocks usually suffer significantly less decline in value than non-dividend-paying stocks.
Owning stocks of dividend-paying companies also substantially reduces overall portfolio volatility. A 2000-2010 comparison of dividend-paying companies versus non-dividend-paying companies Index in Kenya shows a marked contrast in levels of volatility.
The beta of dividend-paying companies over this period of time was 0.98, slightly less than the overall market average.
The beta of non-dividend-paying companies for the same time period was 1.48, showing a much higher volatility rate than the overall market average.
Dividends Offer Tax Advantages: The way dividends are treated in regard to taxes makes dividends a very tax-efficient means of obtaining income. Qualified dividends are taxed at substantially lower rates than ordinary income.
Per IRS regulations as of 2011, for individuals whose ordinary income tax rate is 25% or higher, qualified dividends are taxed at only a 15% rate. And for individuals whose ordinary income tax rate is below 25%, qualified dividends are completely tax-free.
Dividends Preserve Purchasing Power of Capital: Dividends also help out in another area that investors sometimes fail to consider: the effect of inflation on investment returns.
For an investor to realize any genuine net gain from an investment, the investment must first provide enough of a return to overcome the loss of purchasing power that results from inflation.
If an investor owns a stock that increases in price 3% over the course of a year, but inflation is at 4%, then in terms of the purchasing power of his capital, the investor has actually suffered a 1% loss.
However, if that same stock that increased 3% in price also offers a 3% dividend yield, the investment has successfully returned a profit that outpaces inflation and represents an actual gain in purchasing power for the investor.
The good news for investors in dividend-paying companies is that many dividend yields outpace inflation.