Should Investors Even Care About Dividends?

Many investors are desperate for yield, but there are certain situations where paying a dividend might not be the smartest move.

| More on:

Imagine a world where dividends don’t exist. Instead of paying out a chunk of earnings to investors each year, companies are free to use that money to reinvest in their businesses. A company that formerly paid out 40% of its earnings in dividends and reinvested 60% of its earnings would be free to take all its earnings and use them to grow its business.

Say most companies can return 10% of their invested capital. Instead of investing 60% of earnings back into the business to return 10%, the company invests 100%. This company would, in theory, generate a 4% increase in net income compared to a company that divided earnings between reinvestment and dividends. Over time, this would compound into a significant difference.

If investors needed income from such an investment, they could just sell a few shares. Sure, there are tax implications on a sale, but dividends are also taxed. Additionally, an investor looking to avoid tax could just sell a few losing stocks along with a few gainers, trying to keep gains to a minimum. It would work, assuming there are a few duds in the portfolio.

It’s very easy to see the problem in my world without dividends. Most mature Canadian companies can’t identify enough opportunity to invest all of their retained earnings, so they’re almost forced to spend the rest on dividends and share buybacks, much to the delight of most investors.

Take, for instance, Telus (TSX: T)(NYSE: TU). The company has made massive investments in its network, and is now reaping the rewards. The company pays out approximately 70% of its net earnings on dividends, and spends additional money buying back shares each year. These moves help boost the share price, since investors translate dividend increases and share buybacks as bullish signals.

However, what if Telus had a better use for its earnings? The company made $1.3 billion in 2013, and currently sits on about $7.5 billion in debt. I understand that interest rates are low, but you can at least make the argument that Telus should pay off some of its debt. Even at 4% interest, $7.5 billion in debt will set back the company $300 million per year.

In the energy patch, acquisitions happen all the time. Unlike mergers in other sectors, a company looking to buy another one doesn’t  have to worry about things like intangibles or whether something is a good “fit.” Buying oil assets is very much a numbers game.

Each year, Husky Energy (TSX: HSE) pays out $1.20 per share in dividends, good for a 3.6% yield. The company currently has 983 million shares outstanding, which means investors pocket $1.18 billion each year in dividends. What if it used that cash to acquire a competitor?

Over the last decade, shares in Pengrowth Energy (TSX: PGF)(NYSE: PGH) are down more than 45%. Investors have had to deal with poor results, weak natural gas prices, and a cut in the company’s monthly distribution. Shares have rebounded over the past couple years, as the market is optimistic about the company’s move away from natural gas and into oil production.

The company’s current market cap is $3.75 billion. If Husky suspended its dividend for four years and offered the $4.75 billion saved for Pengrowth, let’s argue that it could acquire the company. Pengrowth is projecting funds from operations of just under $500 million in 2014, and is projecting to pay $250 million in dividends.

If Husky immediately added $500 million in funds from operations from a $4.75 billion purchase, that’s an instant 10.5% return. That’s even after paying a 25% premium to acquire the assets. There are plenty of opportunities in the energy sector to acquire smaller chunks of assets that wouldn’t require such a premium.

I understand why investors love dividends. It’s great to get paid now, especially if you’re at a point where current income is important. Despite this, a quarterly payout shouldn’t be the most important reason to buy a stock. I view a dividend as a bonus. If a solid company with growth prospects and a fair valuation happens to have one, great — but if it doesn’t, the stock should still warrant investigation.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Nelson Smith has no position in any stocks mentioned.

More on Investing

Hourglass projecting a dollar sign as shadow

New Investor? If You Do Nothing Else With Stocks, Learn This Lesson

Time is the most powerful thing on an investor's side. Here are two powerful ways to use it.

Read more »

lab worker inspects test tubes
Dividend Stocks

Warren Buffett’s Buying This Passive Income Stock

Berkshire began buying this chemical company earlier this year and hasn't stopped.

Read more »

Arrowings ascending on a chalkboard
Tech Stocks

Why I Think Nuvei Stock Has Market-Beating Potential

Given its growth initiatives, expanding addressable market, and attractive valuation, I believe Nuvei has the potential to outperform the broader…

Read more »

Various Canadian dollars in gray pants pocket
Dividend Stocks

Need Passive Income? Turn $5,000 Into $23.85 Every Month

If you're looking for passive income that comes in like a paycheque, this dividend stock provides that to you along…

Read more »

A worker drinks out of a mug in an office.
Metals and Mining Stocks

5 Things to Know About Nutrien Stock in December 2022

Trading at heavily depressed multiples, Nutrien stock is a great opportunity, as it delivers solid financial results and an optimistic…

Read more »

A shopper makes purchases from an online store.
Tech Stocks

Shopify Stock Rose 15% in November: Is it a Buy Today?

Shopify (TSX:SHOP) stock rallied 15% this month but is still down 69% year to date, so should investors worry that…

Read more »

Man holding magnifying glass over a document

The 3 Most Oversold TSX Stocks to Watch Before 2023

Many oversold stocks are merely victims of market circumstances and potentially profitable bargains when they seem downtrodden.

Read more »

Silver coins fall into a piggy bank.
Dividend Stocks

A TFSA Contribution Room of $88,000 and 1 Dividend Aristocrat Can Make You $172,330 Richer

A high-yield Dividend Aristocrat in the energy sector is a suitable holding for Canadians with $88,000 available contribution rooms in…

Read more »