What I am about to tell you is quite shocking to most investors: I don’t like dividends.
I can hear the outrage already, but hear me out. Dividends are simply cash left over from a business’s operations that they return to shareholders. Simple enough to understand, right? So, what’s wrong with a company paying its investors a dividend?
Theoretically, nothing is inherently wrong about companies paying dividends, as it is viewed as a reward to shareholders. However, there are times when dividends just don’t really make sense for some investors.
When a company pays you a dividend, they are essentially sending you that leftover cash, which gets added to your account balance. The unfortunate part of this is that Uncle Sam views this cash as income, which means you pay taxes on that income.
Now, of course, you can avoid the tax man by receiving dividends in a tax sheltered account, like a Roth IRA. But in a standard brokerage account, you will need to pay taxes on your dividends. As a shrewd investor, I want to limit my tax liability as much as possible, so dividends (and bonds for that matter) aren’t tax friendly assets in your standard brokerage account.
Lower Rate of Return
Generally speaking, when a company pays investors a dividend, the management is essentially stating this as fact:
“Our business is producing so much cash, and we cannot find good opportunities to reinvest that cash, so we will just return it to shareholders”.
When you read this statement, it sounds like good management practice, right? Yes, it can be good practice…sometimes. In certain cases, the business really has no other choice but to pay out dividends, as this will be the most valuable asset to shareholders at the time.
But I generally don’t like this strategy. As a long-term investor, I would rather the company reinvest all its earnings into more profitable ventures that will compound the business, and hopefully, the stock price.
This 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 retain all the company’s earnings in order for them to compound at the highest rate of return possible.
Now, in order for this to be possible, the company’s management has to be exceptionally good at their jobs. This isn’t a problem though, since this is the kind of management we want in charge of our money anyway!
Are Dividends Companies All Bad Investments?
Nope. There are still some good reasons to buy a stock for its dividend. For me, it all depends on the valuation. Before we get into the valuation, let’s talk about the characteristics of good dividend stocks that we would like to buy.
Characteristics of Good Dividend Stocks
Sustainable and Predictable Business
If we want to buy a stock strictly for the dividend, we have to be certain that the company will be around for the long term. We need to analyze the business and ensure that it will be operating for at least the next 10 or 20 years.
Consumer staple companies fit this mold perfectly. Some consumer staple companies have been around for decades, or even centuries. Longevity is key here.
Solid Balance Sheet
In order for a company to pay a dividend, they have to have a sound balance sheet. What we are really looking for here is to make sure that the company does not have any liabilities that would affect the dividend payments. A business saddled with debt will be forced to cut its dividend to pay its borrowings.
Strong Cash Flows
In order to pay a dividend, a company must have strong cash flows. Cash flows from operating activities should be stable and growing annually.
Here is a dangerous scenario that we want to look out for: businesses that borrow money to pay a dividend. Believe it or not, this does happen. This is a sign of poor management. We definitely don’t want these kinds of companies.
Relying on growth in cash flows from operations (not debt) is what we want.
Lastly, in order for dividends to remain valuable to us, we need the company to grow the dividend every year. These companies are known as dividends aristocrats and are some of the most well-known companies on the market.
A company that cuts or suspends its dividend is not what we are looking for. We want to see uninterrupted growth in dividends year after year.
Let’s get down to valuation.
How to Value Dividend Stocks
Yield on Cost Method
The method that I prefer to use when valuing a company strictly for its dividend is the Yield on Cost Method. Yield on cost is simply the dividend per share (DPS) over the share price. This is how we will calculate our returns.
Now, when valuing a dividend stock, I am looking to see how quickly the company can pay me back in dividends for the capital I invested in the stock. Here is my rule of thumb when looking for a good dividend stock:
A company that can offer me a 100% yield on cost within ten years time.
By using this method, after ten years of holding the stock, the company would have paid me back my original capital I invested in the stock. After that time, you get to enjoy the capital appreciation of the share price as a bonus.
Let me run through an example of this.
Tyson Foods (TSN) Example
Before we do any valuation work, let’s run through Tyson’s fundamentals to see if they are a good fit.
Sustainable and Predictable Business
Here is a snapshot of Tyson’s business model:
Tyson has a broad portfolio of meat and poultry products that they sell to millions of customers. I don’t know about you, but I need to eat every day. While I don’t always eat meat every day, millions of other people do. This is unlikely to change soon, especially as the world population continues to grow.
There is a good chance that 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 is.
Solid Balance Sheet
For the past decade, Tyson has operated a clean balance sheet, with its assets (both total and current) outpacing liabilities by a healthy margin. They maintain a current ratio of 1.8 and a quick ratio of 1.0.
Strong Cash Flows
Tyson has been able to grow cash flows significantly over the past ten years. Cash from operating activities and free cash flow continue to grow each year, while capital expenditures are kept in check.
Due to Tyson’s stellar track record, they have been able to consistently grow their dividend every year. In fact, Tyson’s dividend has seen a CAGR of over 26% in the past ten years, growing from $0.12 per share to $1.71 per share.
Now let’s get to the fun part: valuation. To calculate the yield on cost, we only need a few inputs.
The most important inputs here are the expected growth rates of the dividends you expect to receive.
Tyson has seen some stellar dividend growth over the past decade, but in the last few years the dividend growth has slowed, likely because of COVID-19 pressures. In order to have a margin of safety, I estimated that the dividend would grow at a rate of 15% for the first ten years and slow to 10% for the next decade after that.
Here are our outputs:
So, if we buy TSN at the current share price of $76.75, we can see that we will have a 100% yield on cost around year 15. This means that by year 15, as long as Tyson keeps growing its dividend as we expect them to, the dividend will have paid for our stock purchase of $76.75, and you get to enjoy all the dividends and capital appreciation of the stock from there on for free.
Now 15 years is quite a long time to wait. This is where time is on your side. All you have to do is make sure you buy at an appropriate price for the value to make sense.
As I mentioned previously, I shoot to receive a 100% yield on cost at around the ten-year mark. This gives me adequate time to enjoy the “free” dividends and capital appreciation of the stock price for decades to come.
Unfortunately, Tyson did not meet my expectations of providing me a 100% yield on cost in ten years. But let’s say that tomorrow Tyson’s share price falls to $50. If all else is equal, the dividend would now yield 3.4%.
Here you can really see the compounding take place. By year 12, we have received over 100% yield on cost. If we continue to hold for the next 10 years, by year 20 our yield on cost will be over 300%!
This also doesn’t even consider the regular capital appreciation of the stock price over that time period. Your real returns would likely be even better than this.
If you think that this possibly couldn’t happen, over the past three years TSN’s share price dipped to nearly $50 not once, but twice.
Now all this talk about dividends and compounding sounds really cool, and it is. But the thing here to remember is that you have to buy deals like these when things get rocky. Over a year ago when we saw the COVID crash, nobody wanted to buy a stock like TSN that may have offered them a solid yield on cost.
This is what real value investing is all about: Simply buying wonderful companies at bargain prices.
So after all this talk of dividends, why don’t I like them? Well, to put it simply, dividends are great if you want/need the cash now. This is why so many retirees hold dividend stocks, and as we have seen, it makes sense if you have decades of time to receive dividends.
In a regular taxable investment account, I would have to pay taxes on the dividends I receive. However, this strategy could work out to your advantage if properly invested in a tax advantaged account.
But for me, I don’t need to have my investments return cash to me at this point in time. I prefer to put my capital into a company that will compound the business at an even higher rate of return (through stock buybacks or capital appreciation of the stock) without ever receiving a dividend.
That being said, I continue to be on the lookout for good deals like this that are presented from time to time. But in a frothy stock market with high asset prices, I am more likely to purchase high-quality stocks at fair prices rather than at decent stocks at bargain prices.