Dividends are becoming popular again. Let’s have a look at the history and importance of dividends.

First a definition

Investorwords.com defines dividends as follows: "A taxable payment declared by a company's board of directors and given to its shareholders out of the company's current or retained earnings, usually quarterly. Dividends are usually given as cash (cash dividend), but they can also take the form of stock (stock dividend) or other property. Dividends provide an incentive to own stock in stable companies even if they are not experiencing much growth. Companies are not required to pay dividends. The companies that offer dividends are most often companies that have progressed beyond the growth phase, and no longer benefit sufficiently by reinvesting their profits, so they usually choose to pay them out to their shareholders. Also called payout."

A quick history

Dividends have existed since the first traders met under a Buttonwood tree at 68 Wall Street in the late 18th century. The role that dividends have played in investing has changed considerably since then.

Initially, investors demanded that the entire earnings of a corporation be paid out annually due to concerns that any cash in the corporation could be lost. Investors considered equity investing a risky proposition so getting your capital out from a venture was very important. As a result, for the first 150 years of organized markets, equities typically yielded more than bonds. The reason was simple - equities were riskier than bonds so they yielded more to compensate an investor for taking the risk.

Stocks were treated like bonds with annual payouts that varied depending upon the fortunes of the company. It was not until Ritchie Cunningham and Pat Boone that attitudes began to change and it became acceptable for companies to retain some earnings. As a result, stock prices began to rise and equity yields fell below bond yields. When this happened for the first time in 1958 many older investors thought the world had gone mad. Imagine - risky equities yielding less than government bonds!

Historically, dividends have played a large part in equity returns

Since 1910 the average annual return for US equities, excluding dividends, has been a scant 2.2%. The other 6% of the long-term return resulted from dividends and their reinvestment. This should not be a surprise to anyone since equities yielded more than bonds from 1910 to 1958. In the short run, price dominates return - over longer periods of time the reinvestment of dividends has a large impact.

An illustration of the power of dividend reinvestment

To illustrate the power of dividend reinvestment, we reviewed TD Bank's performance from March 31, 1990 to December 31, 2006. While it can be dangerous to generalize based on the results of one company, the example is instructive. 

In our calculations, we assumed an investment of $1,250 each quarter ($5,000 a year) with and without re-investment of dividends in TD stock. During this period, the stock price rose from $8.88 in March of 1990, to $44.20 in September of 2000 and then retreated to $27.77 at the end of September 2002 before closing at $69.72 on December 31, 2006. Meanwhile, the dividend rose from $0.38 a year in 1990 to its present $1.92 per share. 

During this period, the annualized return attributable to stock price appreciation (i.e. assuming no dividends) was 14.2%. Adding the impact of dividend reinvestment increases the annualized return on TD stock by 3.75% per year to 18.0% over the period. The most interesting observation, however, is what happened to the dividend "yield at cost". 

The dividend yield at cost is equal to the total dividend payout at any particular time divided by the total cost paid for the stock. Over the 16-year period considered, TD Bank's dividend yield at cost rose steadily from 2.4% to 8.7%. Although dividend yields during the period didn't increase materially (they bounced around between a low of 1.9% and a high of 4.7%), the absolute increase in dividend payments and the reinvestment of those dividends paid off handsomely. 

US Tax Reform

In 1954, US couples could exempt $100 of dividends received each year for tax purposes - this doubled to $200 in 1964 and doubled again to $400 in 1980 (almost US$1,000 in today's prices). This changed in 1986 - the US government wanted a piece of the dividend pie and therefore repealed the dividend exemption in the 1986 Tax Reform Act. After 17 years without any tax relief the Bush administration is now considering changing the way dividends are taxed.

Today, when a US company earns $1, it pays 35 cents in corporate taxes. If it then distributes a 65-cent dividend to a shareholder, that shareholder is often required to pay an additional 39% tax on the dividend. After tax, there is only 40 cents left. This represents an overall tax rate of almost 60%.

For this reason corporations have limited the amount of dividends they have paid and have been increasing the amount of shares they buy back from investors. (By repurchasing shares, corporations increase the equity represented by each share.)

Currently the dividend yield on the S&P 500 is a paltry 1.8%. Adding back the value of share repurchases, however, results in a yield of 3.25%. This represents a significant gain compared to the 1.15% that treasury bills yield.

The Bush tax plan may eliminate the corporate tax on dividends but will most likely re-instate a dividend tax exemption for individuals. The result of such a change would be to increase the after-tax rate of return on all dividend-paying stocks that should lead to higher prices for these companies. As a result of these potential changes, a dividend-paying stock that had provided a 3% after-tax yield could all of a sudden yield 5%.

To summarize:

   1. Dividends are an important contributor to long-term equity performance

   2. Future dividend yields are likely to lie somewhere between the minimal payments of the late 1990's and the higher yields of 100 years ago

   3. The Bush tax reforms could result in higher prices for dividend paying stocks and more companies starting to pay dividends

It seems that after all these years dividends are regaining their importance in investing.