You mentioned that dividends can sometimes be too low or too high. I understand what is too low: zero, obviously. But what is too high? And why would it matter? Wouldn’t high dividends be better than average dividends? — M.K.
In the post How I Invest , I mentioned that just because a company pays dividends does not automatically make it a good investment.
Some companies do not pay dividends. So it would be a rare thing for a dividend investor to purchase shares in such a company.
What is Low Dividends?
Some companies pay very low dividends. I would consider dividends less than a 2% yield to be low in most cases. That does not mean the company does not have good prospects. In fact it may be a good prospect for a dividend investor. All it means is to be aware.
When a company pays dividends, it shows that they have enough cash to maintain and grow their business and pay shareholders. Investopedia has some good writeups about dividends in general at here and here.
Where and when did dividends start?
The first corporation organized as a public stock company, was the first to be listed on a stock exchange, and was also the first company to issue dividends. The Dutch East Indies Company (also known as United East India Company, or the United East Indian Company, or the United East Indies Company) was founded in 1602 in Amsterdam.
In the 1600s the size of the Dutch merchant fleet, of which the Dutch East Indies Company was an integral part, was estimated to exceed the combined fleets of England, France, Spain, Portugal, and Germany.
Why would companies pay low dividends?
A company can pay low dividends for a number of reasons. Perhaps management thinks that most or all funds generated by the business are needed by the business. Perhaps management does not believe in paying dividends to shareholders. Perhaps they are concerned about the ability to pay out funds better used for future growth. There could be many other reasons.
Some companies want to be known as dividend payers but want to keep their dividend costs low. So they do not pay much.
There is also the divide between growth companies and value companies. This is a topic worthy of a larger discussion. (A general explanation is here: ) But to generalize, you will find more dividend payers as value companies than as growth companies.
So what is High Dividends?
First let’s talk about dividends in general. When a company reports its quarterly results, they include the information on how much it earned “per share”.
Namely, if a company earns, say, $1,000.000.00 in a quarter, that is useful information, but other information is needed, such as knowing how much the company earned in the previous several quarters so we can compare results.
If you take the earnings amount and divide it by the number of outstanding shares, that tells us the earnings per share (EPS).
If we calculate the amount of dividends paid per share, we know what percentage of the earnings per share were paid as dividends. This percentage is called the dividend payout ratio, or dividend ratio.
Ratio, Ratio, Who’s Got the Ratio
If the dividend ratio is moderate or low, then we can see that although the company is paying dividends, it also has retained most of its earnings for day to day operations. Anything over 60% can be considered something to be aware of. Occasional spikes over 60% may not necessarily be alarming if the percentage subsequently drops. But if the percentage is consistently over 60% and rising, then we have cause for concern. Use of the 60% cutoff is debatable, but it as good as a marker as any.
Historical note, continued
The Dutch East Indies Company had a dividend payout ratio of 18% per year during its almost 200 year history. This is much higher than current companies. But previous to its formation, there were no other companies to compare it to. Prior to its founding, individual merchant voyages were financed as independent companies, and when the voyage was completed, the venture was liquidated. The innovation of the Dutch East Indies Company was to form an ongoing company.
By 1669, the Dutch East Indies Company was the richest private company the world had ever seen, with over 150 merchant ships, 40 warships, 50,000 employees, a private army of 10,000 soldiers, and a dividend payment of 40% on the original investment. (Information courtesy Wikipedia.)
Oh My Ratio, I Knew It Well
Once in a while you may encounter a situation where the dividend ratio of a company is near or over 100%. This means that company is paying out all (or more) of its quarterly earnings in dividends. This is a red flag for dividend investors and in such a case it is prudent to be very cautious. That kind of situation cannot continue for very long; it would normally mean the company is either borrowing heavily to maintain its dividend, or it is selling assets to maintain its dividend. Personally, in most cases it means I would normally avoid that company’s shares.
However, during times of sharp economic volatility, the payout ratio can vary widely. If a company experiences a sharp decline in earnings, but decides to maintains its dividend, the dividend ratio can spike. At times like these, one should consider whether the decline in earnings is temporary, or part of a long-term trend.
The average dividend ratio of the S&P 500 between 1960 and 2017 was 45%. The recent Dow Jones Industrial Average dividend ratio is somewhat smaller at about 32%, but was over 50% going back to the 1930s.
Let’s not confuse dividend payout ratio with dividend yield. Dividend payout ratio is the percentage of Earning Per Share paid out as a dividend. Dividend yield is the measure of the percentage of the stock price you are receiving as a dividend.
It is appropriate to compare dividend yields with historical trends to get a perspective. At this time, the broad S&P 500 index has slightly more than 400 companies that pay dividends, and the average yield (as of this writing) is 2.22%. All thirty stocks in the Dow Jones Industrial Average pay dividends and the average yield is 2.42%.
The dividend yields on S&P 500 companies that pay dividends ranges from 0.02% to over 12%. Since that is a very large range, it is not useful as a realistic guideline.
The dividend yields of the DJIA stocks range from 0.68% to 4.62%.
So we see that a yield between 2% and 4% is common and average. Sometimes up to 5% or 6% is encountered. Above that raises questions about risk. You may have another opinion.
When we say that yields between 2% and 4% are common and average, we are talking about in today’s economy. Dividend yields are generally influenced by interest rates. The most significant and influential interest rate of all is that for U.S. Treasuries. If these bonds are paying a low interest rate, so we would expect stocks to do the same. If rates are higher, so expectations are higher for dividends. (I’m talking about dividends in the U.S. for U.S. investors, of which I am one. Other countries have dividend yields that are much different that the U.S.)
Thinking About 4% Yield
That is not to say that I don’t have shares in any companies that pay over 4%. At present, I own shares in three companies yielding between 4% and 6%. However, I have shares in those companies because I have held those for many years, and had acquired them when their yields were more average. I am not adding to them at the present time.
Since yields vary just as share prices vary, all things being equal, I suspect that over time, these higher yields will come down. In fact, as share prices rise, the yield declines if the dividend does not change.
When a stock has a very high dividend yield, even over 12%
A very high yield may entice some investors. This situation is often called a “dividend trap.” An investor buying the stock for a high yield may find themselves with a company that eventually implodes or goes out of business. That result is not guaranteed, but it can happen. On the other hand, it may be possible for the company to repair itself. But in either case, this is a high risk situation.
To avoid risky situations, these days I aim for large stable companies whose stock yield is normally in the 2% to 4% range, whose dividend ratio is 60% or less. The company should have increased profits and dividends for years, and whose products are in demand.
This discussion only scratches the surface of dividends. For anyone thinking of investing, the more reading and research one does, the more one is prepared.
What is your take in dividends and dividend investing?