Sunday, October 12, 2008

Dividend Yield: Does It Matter?

All else equal, is it better to own a company with a higher or lower dividend yield? Theoretically, ignoring certain tax implications, it makes no difference. The company with the lower dividend gets to re-invest the retained earnings to generate more cash in the future that makes up for the current lower payout.

In practice, however, companies with higher dividend yields actually outperform the market. In a study by Bauman et al, researchers discovered that stocks in the highest dividend yield quartile outperformed those in the lowest by 4.8% per year, which translates to huge portfolio differences over a long period of time.

There are many theories suggesting why stocks with higher dividend yields offer better returns. One popular theory is that investors are overly optimistic (and thus overpay) for growing companies with "future" earnings that don't end up materializing. Another theory is that companies that don't pay dividends end up wasting their retained earnings on projects that don't generate the same returns as the core business that generated the original earnings. Evidence of this theory is embodied in the fact that when a company does nothing but increase its dividend, its share price rises, even though theoretically the company hasn't changed.

Whatever the reason, investors who purchase companies that place a priority on returning money to shareholders fare better than those who do not.

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