Many investors love dividends, and for a good reason. While profits from a price increase of a stock are unpredictable, dividends provide you with a (nearly) certain, consistent source of income from your investments. Still, Warren Buffett is not a huge fan..
The downside of dividends
When a company does well and generates a nice income, the company can use this income to grow the business further or it can decide to pay out a part of this income to its shareholders in the form of dividends. The amount of money that is paid out as a dividend as a percentage of net income is called the payout ratio. The money that is reinvested back into the business is called retained earnings, and retained earnings is what drives growth.
The thing with dividends is that they lower retained earnings and therefore slow down future growth. This is the reason why Buffett is skeptical towards dividends. In his eyes, the only reason a company should ever pay a dividend is if it makes business sense to do so. In other words, only if the company has no better use for the money and is unable to earn a high enough return on their retained earnings does it make sense for them to pay the money out as a dividend. If, on the other hand, a company is generating high returns on capital, it is better for the company to keep the money themselves to finance further growth.
I mean, if you found a company which is capable of earning a 30% return on capital, would you want them to pay you a dividend which first gets taxed and which you then have to reinvest somewhere else, or would you rather let them keep all your money so it can compound at 30% annually?
I thought so…
So, dividends can provide you with a great source of steady income from your investments, however, they do get taxed, they detract from retained earnings and therefore lower growth potential. So if, like Warren Buffett, the highest possible return on investment is your goal, then you should probably be skeptical towards dividend paying companies. In the end, it all depends on what your investment goals are.
If you do decide to invest in dividend paying companies, check if dividends are sustainable by looking if the payout ratio is reasonable. Secondly, see if the company has a history of increasing its dividends. Finally, make sure that the company is paying a dividend because it has no better use for the money and not just to keep shareholders happy.
Nick Kraakman, valuespreadsheet.com.