Why Dividends Matter

Dividends play an important role in the total return investors receive from their investment portfolios.  The formula for total return is the sum of stock price change plus dividends (total return = price change + dividends).  When a company pays a dividend, it is returning a portion of the profits it earned to its shareholders via a cash distribution. Investors often view dividends as both a reflection of the company’s past performance as well as its potential for future growth. In 2024, among the constituents of the S&P 500 Index, there were 407 companies which distributed a cash dividend to shareholders. In the decade between 2010 and 2020, dividend paying S&P 500 stocks had an average annual total return of +14.05% versus +13.12% for non-payers. During that period, the dividend contribution to total return rate was 17%. Since 2020, a group of growth oriented large-cap technology companies (think “magnificent 7”) have dominated the S&P 500 and resulted in an overall lower dividend contribution rate of just 12%.  

What can dividends tell us about a stock and the company paying the dividends? Actually, quite a lot. First, dividend paying stocks not only provide some income during periods of declining equity markets, they also tend to smooth out portfolio volatility as they often have a beta under 1.0. During periods of low interest rates, the promise of both a dependable return and lower volatility may suggest to some investors that dividend paying stocks are a proxy for fixed income assets, like bonds. This notion can backfire however as dividend paying stocks, while providing both stability and downside protection, will be more volatile and exposed to deeper losses than investment grade domestic fixed income assets. The ability to grow its dividend payments is often viewed as a reliable indicator of a company’s financial health and stability. Companies that consistently grow their dividends often exhibit strong fundamentals, clearly communicated business plans and a firm commitment to their shareholders.  Another school of thought is that the pressure to both pay and grow dividends imposes a fiscal discipline on companies that is a positive and meaningful one for all stakeholders.

With this new knowledge, should we now invest in the highest dividend yielding stocks we can find? Not so fast.  Studies have shown that, as a group, those stocks within the S&P 500 with the highest dividend payout are not often among the top performers when based on total return. There are several reasons for this finding. First, many top dividend paying stocks are found in slow growth sectors like utilities and telecommunications. In these sectors annual total return often comes more from the generous dividend than from stock price appreciation.  A second factor to consider is the dividend payout ratio which is calculated by dividing the yearly dividend per share by the earnings per share. The payout ratio is then the percentage of total corporate profits that are paid out to shareholders in the form of dividends. Except for real estate investment trusts (REITs) and Master Limited Partnerships (MLPs), both which have payout ratios over 90%, most analysts consider a safe forward-looking dividend payout ratio to be between 40% and 50%.  A payout ratio in this range provides income for shareholders while leaving ample corporate cash to invest in research and development or expansion of the business.  Low payout ratios may suggest that the company prefers to use most or all its profits for investment in its business or for the repurchase of shares.  At the end of 2024, the dividend payout ratio of the constituents of the S&P 500 was 35.78%, leaving some room for growth.  The combination of the current low payout ratios, strong corporate profits and large cash reserves could provide favorable conditions for dividend seeking investors going forward.