March 9, 2005

Dividend Basics
by John Brasher, CallWriter Publisher

Surprisingly to me, there has been a lot of debate down the decades about corporate dividends. Some writers maintain that it is pointless, perhaps even harmful, for companies to pay dividends. Others (like me) believe that dividends are an essential part of the market's rhythm. There are some cornerstone concepts regarding dividends that are important for investors to understand.

Dividends and What They Portend

Virtually all mature, profitable public companies pay a cash dividend to shareholders, which actually is a distribution to the owners (stockholders) of a part of the company's earnings. Dividends must by state corporate law be paid out of current or retained earnings. Dividends are widely considered by investors to provide a valuable gauge to the company's health. A company's willingness, and ability, to pay dividends through the years indicates its stability. Dividends provide needed income for many investors and provide a strong measure of certainty concerning the company's prospects. An increase in the dividend is considered a strong sign that bodes well for the firm's future (and vice versa, as noted below). A company generally is viewed quite favorably when it initiates a dividend; it in effect is joining the big-boy club.

Growth companies frequently do not pay dividends, preferring instead to use their cash to spur growth, on the assumption that the growth in the stock price is more valuable to their stockholders than a dividend would be. That assumption works so long as the company's growth continues at a high rate, but as the company matures and growth slows, it will tend to pay dividends to keep shareholders in their seats, because the continued reinvestment of dividend cash in the business gets spread across less and less growth. Investors want growth in value or dividends. Microsoft, which for many years paid no dividend, is a classic example. By paying dividends, a company essentially is conceding that the growth obtainable from reinvesting profits may not provide as great a return to investors as the dividend payments. Initiating dividends is a consequence of protracted success and a validation of the company.

Are Dividends Important?
For several reasons, yes. For one thing, dividends cannot be faked (unlike accounting measures such as earnings) - the check cashes or it doesn't. For another, stocks that pay dividends are much less likely to reach ridiculous values in a bear market. This is why so many companies with strong dividends outperform the overall market in a market decline. The other side of the coin is that the dividend-paying stocks usually never fly as high as the growth stocks in a bull market. Dividends thus are a much more important factor for investors in flat and declining markets, but much less important in bull markets, when investors are looking for a quick buck due to market forces. A fast-growing company should not divert precious cash to shareholders, but any company should be delivering either high growth or reasonable dividend. Why else would you own it?

There are those who oppose dividends, though, as cash giveaways. They argue that shareholder interests are better served by using the cash to drive growth (through revenue generation, acquisitions, etc.) or repurchasing shares. And if the company is delivering high growth (and quality growth), the argument makes sense. But if the company is mature and growth is incremental, investors are not as willing to hold the stock without the dividend income stream. Again, the company has to deliver either growth (and the stock had better appreciate, too) or income. In answer to the argument that dividends are not that helpful to shareholders anyway, due to high taxation, the income tax rate has been lowered for qualifying dividend income. Another argument is that dividends are unnecessary because shareholders have other ways to generate income, such as writing covered calls. But that argument misses the point. Give me growth or give me dividend!

On the contrary, not paying a reasonable dividend can actually result in harm to shareholders. Hoarding cash can lead to excessive executive compensation, poor management, and employing assets in unproductive ways. One study found that the more cash a company keeps, the more likely it will overpay for acquisitions. Dividend-paying companies tend to be more efficient in their use of capital than similar companies that do not pay dividends and are less likely to engage in funny accounting. After all, for mature companies the proof of the pudding is in the dividend check. It is the growth companies that cook the books to show income. Dividend payers also provide substantially greater returns over time. According to Ned Davis Research, since 1972, companies that raised or began paying dividends returned an annualized 10.2%, on average, compared to 4.4% for the non-dividend payers - over 2.5 times the return. Companies that consistently raise their dividends are above-average businesses that yield an increasing income stream. Right now, even with the market at a several-year high, dividend stocks are hot. Am I suggesting that traders forsake covered calls for dividend stocks? No. But dividend stocks have implications for covered writers, as the note below discusses.

Trade Tip:  These basic dividend facts have implications for covered call writers, since the goal in covered writing is to choose stable stocks that offer good premium. A steady dividend history is not a bad place to start in the chain of analysis. While the premium income will not generally be as good as with growth stocks, dividend payers tend to be less volatile. Also, more expensive. Writing calls consistently on dividend-paying portfolio stocks, which can double or triple the income stream, is an excellent income strategy.

Measuring Dividends
The dividend yield compares the amount of annual dividend income to the share price. Dividend yield is the annual dividend per share divided by the share price. Thus if the annual dividend per share is $1.00 and the stock price $20, the dividend yield is 5%. The yield allows comparison of the income potential of a company compared to other stocks in the same industry. A low yield compared to industry peers may simply indicate a judgment by management that the company does not need to pay high dividends. It could also mean that the company cannot afford to pay dividends commensurate with those of peer companies.

Note:  CallWriter members can instantly find the dividend yield for any company by clicking the company's name on the Real Time Lists™ (which opens the CallWriter Research Page). The dividend yield percentage will be shown on the Snapshot page that opens.

The dividend coverage ratio, on the other hand, measures the company's ability to pay its stated dividend. To calculate the ratio, earnings per share is divided by the dividend per share. Thus if the company earns $5.00 per share for the year and pays a $1.00 annual dividend per share, the coverage ratio would be 5, indicating that 20% of earnings are being paid to shareholders. A coverage ratio of 2 to 3 is just about right. Below 1.5, the company is hard-pressed to pay the dividend, and below 1 the company is paying it out of retained earnings, a terrible practice. On the other hand, the further above 4 the coverage gets, the more question there should be why the dividend is so low.

Then there is the dividend discount model, which aims to value a stock today based on a discount of estimated future cash flow (the dividends). Predicted future dividends are added and discounted back to present value to arrive at the current "value" of a share of stock under the dividend discount model. A share is considered "undervalued" if the value obtained from the model is higher than the share's current price; and "overvalued" if the model price is lower. The model assumes what the future dividend cash flow will be, and thus suffers from the same flaws as other hypothetical measures. And there are many variations of the formula. The valuation reached is only as good as the inputs used to compute it. Still, a valuation model has to start somewhere, and a lot of finance types use the dividend discount model.

How the Ex-Dividend Date Works
Payment of a dividend is never automatic, and the company's board of directors must authorize (declare) payment of the dividend. There are four critical dates related to each dividend declared:

How the Ex-Dividend Date Works
The ex-dividend date is used to make sure dividend checks go to the right people. The ex-date is the second business day before the record date. As the example below illustrates, if the record date is on Friday the 16th, the ex-date would be the preceding Wednesday the 14th. It is structured this way because of the way stock trades are settled under the current T+3 system, which means that trades must be settled (stock delivered by the buyer and paid for by the purchaser) on the third day following the trade ("T").

If you buy on the ex-dividend date (Wednesday), which is only two days before the record date, you will not receive the dividend, because the trade will not yet have settled by the Friday record date. In order to receive the dividend, you would have to buy the stock on or before Tuesday the 13th in the above example in order for the trade to settle by the Friday record date. If the stock is bought on Tuesday, for example, then the trade would settle on Friday, and the buyer would receive the dividend.

Trade Tip:  In order to sell the stock and still receive the dividend, you must own the stock while it is still cum dividend (before the Wednesday ex-date in the above example) and sell it on or after the ex-date. This applies of course to covered call writers, as well.

Types of Dividends

The two main types of dividends are cash and stock. Cash dividends typically are paid quarterly, sometimes semiannually. Occasionally a company will declare a one-time dividend, such as the $3.00 dividend Microsoft paid in 2004. This is known as an "extra" dividend. The stock dividend (known in olden days as a "scrip" dividend) is paid in the the form of shares of the company's stock. Stock dividends are usually paid when the company is short of cash.

To Pay or Not to Pay

A company is not required to pay dividends, even if that has been its historical practice. The board has pretty much absolute discretion whether to declare them. Sometimes companies cut dividends or even suspend them entirely when the going gets tough in order to use the cash for working capital. Cutting, much less suspending, the dividend works a real hardship on those shareholders (usually older persons) who depend on dividend income. Moreover, investors tend to view a steady dividend history as a mark of a good investment stock. A mature company that cuts, or worse, stops, the dividend can expect the stock to plummet. A drop of 30% or more can easily occur. Not surprisingly, companies don't like to cut or suspend the dividend unless it is necessary. On the other hand, the market can penalize a company that continues to pay a fat dividend when payment would be a poor business practice in light of the company's current financial picture.

Taxation of Dividends

As of this writing federal tax law provides a break on the taxation of dividends for "qualifying dividend income." Taxation is too large a subject to cover in this article, but I have already described the taxation of dividends and the ramifications of covered call writing on dividend taxation in detail in an earlier article. To read it, click here.

Do dividend payments affect covered call writers? Yes! Next week's newsletter will explore the effects of dividend payments upon the prices of options and the underlying stock.

Question:  Would it be a feasible covered call trading strategy to concentrate in calls that have a high open interest (OI), which indicates strong liquidity in the call series, and to avoid calls with low OI?

Answer:   Not necessarily. The level of OI is only one factor to consider in trade selection. While I tend to avoid low-OI calls, keep in mind these factors:

Good luck and good trading!