Those Icky, Gross, Yucky Dividends

My buddy Brian is an aspiring economist, and he made quite the astute analogy;

"I'm seeing people treating stocks like baseball cards. They're buying pack after pack of baseball cards trying to find the Mickey Mantle rookie year card, and there's this annoying piece of gum that they throw away. When in reality the only thing of value in that pack of baseball cards is the piece of gum. And people are completely disregarding dividends in the same matter."

He was right, and probably more so than he realizes. For when it gets down to it, the only thing that drives the value of a stock, the only thing that gives a stock its value is dividends, not earnings.

The reason why is that the shareholder never sees all the earnings, only the dividends. The corporation may reinvest profits and only pay out a fraction of that in dividends, but that still doesn't change the fact the only cash flow is dividends.

Now some will argue, "Yeah, but when I sell the stock, I get a capital gains, it's worth more than what I bought it for."

True, but that doesn't change the fact dividends are still what's driving the value of that stock. Whoever buys it from you, is not buying it now in hopes of selling it for more later, they're buying a future string of dividends. In other words, if you held onto the stock, in truth the only thing giving it value is its future dividends.

The only time there is a "genuine" capital gain is when the company is bought out by another. Otherwise the firm either dissolves or goes bankrupt and you have no capital gain. Thus, the entire history and value of a stock is not what profits it made, but what dividends it meted out to its shareholders.

Sadly though, and perhaps through the goggles of retirement planning and 401k's we look at stocks as purely capital gain investments. We rarely care about dividends and presume we'll be able to sell stocks for more when we retire.

There's just one minor problem. The true driver of value for stocks is going down, relative to the price you have to pay. In other words, you have to pay more in stock price to get the same paltry amount of dividends. This is measured by what's called the "dividend yield."

The dividend yield is dividends divided by price. In other words what percent return will you realize from investing in a stock given its price and the dividends it pays.

Roughly the dividend yield has averaged around 5%, meaning you could expect to receive a 5% return in the form of a dividend. Not terribly much, but it was a little more than inflation. But with stock prices being driven by retirement money and less by earnings and even less by dividends, the dividend yield has been driven down below 2% and has been there for the past decade. Even with the stock market crash in 2000 and even with our significant correct today, it's still below 2%.


The reason again is not that dividends have gone down, but prices have gone up so much driving the ratio down. Sadly this little tidbit of data is making me ever more convinced that stocks are going to be coming down like housing once the boomers retire.