Portfolio Managers • Advisers • Financial Planners











Using Dividends as the Primary Metric for Determining Value

The most commonly used metric for determining value of U.S. stocks is P/E (price to earnings ratio). Numerous studies and value investors claim that high P/E ratios tend to result in lower future returns. Yet, due to price and earnings volatility, P/Es change quickly and at times irrationally. The PE(10) (price divided by the average of the past ten year’s earnings) was popularized in Robert Shiller’s book Irrational Exuberance. Shiller continues to post the PE(10) data for the S&P earnings publicly.

The chart below depicts PE(5) for over 100 years:

The dividend yield (divided to price ratio) is based on dividends rather than earnings. Importantly, dividends are harder to manipulate than earnings. They are either paid or unpaid and are not as subject to interpretation, channel stuffing, accounting determinations, or other subjective measures.

Further research suggests that dividend policy (the general attitude corporations have towards determining dividends) changed after World War II. Prior to then, dividends were usually paid as a fixed percentage of earnings. Therefore, as earnings fluctuated from year to year, dividends fluctuated proportionately. Afterwards, dividends became a form of information signaling as dividends were set to represent the minimal level of future expected earnings. In other words, except under extraordinary circumstances, dividends should not



decrease. Investors have come to expect reliable dividend rates, and many companies now have very long histories of continually increasing dividends. This chart shows P/D for over 100 years:2

In the recent recession, several such companies lost that distinction, the most pronounced being Dow Chemical when it broke a streak of 95 years of continuous dividend increases. Pfizer broke a streak of 41 years. Both of those companies were involved in large acquisitions (Rohm & Haas and Wyeth, respectively), but other stalwarts such as General Electric and major banks cut dividends. Certainly, dividend payments are not guaranteed, and they are entirely subordinate to all liabilities, including bond principal and interest.

However, due to the stigma associated with cutting dividends, directors are generally willing to exhaust other available means of preserving cash flow first. Similarly, during boom times, they are less apt to raise dividends on par with earnings growth.

We believe many companies use cash from operations in the following order of priority to: 1) pay dividends; 2) fund capital expenditures; 3) make acquisitions; and 4) to buy back stock, and therefore an increase in dividends usually means the company sees future earnings growth

© Dower Strategic Capital, 2012











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