Why you can't afford to ignore dividends

In the 1990s, conventional wisdom dictated that companies should reinvest their earnings. But investors should appreciate dividends, for one key reason.

Back in the 1990s, investors couldn't have been less interested in dividends. Instead of paying out some of their profits to shareholders, the conventional wisdom said, companies should devote all their earnings to reinvestment in jazzy new technologies. This strategy fuelled even faster profit growth and share price rises. But since the collapse of the technology bubble and the emphasis on fast-growing stocks, investors have again come to appreciate regular cash payments from their equity investments and not just because it's harder for a firm to fake earnings if it has to pay a portion of them out. Studies also suggest that the more cash a company keeps, the greater the chance that it will squander it.

Dividend-paying stocks: long-term returns

But the key reason that investors can't ignore dividends is that provided they are reinvested they comprise the bulk of long-term returns. According to the latest annual Barclays Equity Gilt Study, a £100 investment in UK equities in 1945 would have been worth an inflation-adjusted £4,061 by the end of last year with dividends reinvested; had they not been, the initial stake would have grown to just £279. Starting with £100 in 1899, the respective figures are £22,426 and £197. It's a similar story in the US, where a study of the stockmarket by Jeremy Siegel showed that between 1871 and 2003, 97% of real returns stem from reinvesting dividends, and just 3% from capital gains.

The statistics reflect the tendency of dividends and hence the dividend yield on shares, that is, the price divided by the annual dividend per share to rise over time, says Nick Louth on Money.uk.msn.com. Dividends have grown by an annual average of 6% to 7% since 1945. On £100 worth of stocks yielding 4.5%, a 6% yearly dividend rise would treble the yield to 13.1% (based on the price paid for the shares) in 20 years. Reinvestment of that yield would have boosted the total payout by a factor of 15. A bondholder, by contrast, would still be getting the same yield 20 years later.

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Dividend-paying stocks: attractive to buyers

Dividend-paying stocks, moreover, are safer than their non-paying counterparts: as many investors pay close attention to the dividend yield, when the price of a stock declines to a level resulting in a tempting yield, it tends to attract buyers, provided investors are convinced that the firm has the wherewithal to sustain them. A non-paying stock offers no such buffer.

When it comes to picking dividend stocks, it's worth checking that the company has a record of consistent dividend growth. This buoys confidence in its long-term growth potential, says James Glassman on Kiplinger.com, who also notes that consistent payers have outperformed the overall US market. Moreover, firms with long payment records will be loath to alienate investors who have come to expect sustainable dividend expansion, and should thus run their firms prudently enough to be able to avoid halting, or even cutting the dividend, says Morningstar.com's

Josh Peters. Another tip is to watch out for unusually high yields, which may indicate a company in trouble or a forthcoming dividend cut.

Dividend-paying stocks: gauging security

To gauge how secure a firm's dividend is, check its dividend cover, or how many times the dividend could be paid out of post-tax profits (this figure is provided every Monday in the FT share listings, but can be calculated by dividing net profits by the total amount paid out in dividends). A figure of under one is a red flag, as it implies that the dividend is unaffordable without borrowing. A ratio of over three is usually deemed comfortable, says Motleyfool.co.uk.

It's also worth keeping an eye on debt. Interest cover, quoted by most analyst research, compares operating profit (earnings before interest and

tax) with interest charges. Cover below four or five is dodgy, says Louth.

"The first casualty of growing debt is often the dividend".