“The only thing that gives me pleasure is to see my dividend coming in.”
— John D. Rockefeller

For many long-term investors, dividends are the straw that stirs the drink. Over time, a stock’s share price represents the present value of all future dividend flows. In return for investing cash into a company, an investor receives a reward of dividend income.

Q: What are dividends?

A: In general, dividends are cash payments out of earnings from the company to its shareholders. Dividends provide a critical insight into the board of directors’ perspective on the company’s financial health, growth, and value.

Q: How important are dividends to the long term performance of equities?

A: Very important! An April 2008 Eaton Vance white paper, written by Judith Sarayan and Michael Allison, explained that dividends accounted for some 50 percent of a stock’s returns since the 1930s.

Shares of stocks that pay dividends possess investment value because they return cash from earnings to its owner. Without the prospect of earnings to pay dividends, stocks are just worthless pieces of paper.

A company’s willingness and ability to pay steady dividends provide good clues about its fundamentals. Companies paying dividends are usually stable rather than “fast growers.” Dividends should be “sticky” — for they imply management’s willingness to pay cash into the indefinite future because they believe that the company’s business prospects are bright.

My mother used to say that a company that can deliver steadily increasing dividends, not diamonds, is a “woman’s best friend.”

Josh Peters, in the book “The Ultimate Dividend Playbook,” argued that a dividend payment is the ultimate sign of corporate strength because it shows that the company’s board has not only direct interest in the shareholders — the ultimate owners of the business — but also the ability to pay out cash.

Q: Is the dividend safe?

A: Dividends are not binding commitments. Howard Silverblatt, senior analyst at S&P, reported that from Jan. 1, 2008, until the end of April 2009, 20 percent of the S&P 500 companies have reduced their dividends.

By April 2009 the wipeout of dividend income, some $40 billion, already surpassed what was eliminated in all of 2008. Forty-one companies in the S&P 500 cut their dividends already this year. In all of 2008, 61 companies cut dividends.

To determine the safety of the dividend, many experts look at earnings on a per-share basis. These analysts draw comfort when the dividend payout is less than 35 percent of earnings. Stated differently, a company’s earnings could decline by 65 percent before it would need to borrow the cash to pay dividends. Companies with the following characteristics possess more stable stream of earnings and provide better dividend protection.

• Strong patent protection, brand-name recognition or hold franchises — an “economic moat” — generally means a company possesses income stability because it has erected barriers against competition.

• Few fixed costs that allow companies to reduce business costs during slowdowns.

• Little financial leverage reduces interest rate burdens.

S&P compiles a list of companies called the Dividend Aristocrats. These companies have consistently increased dividends every year for at least 25 years. Proctor and Gamble might be king of the hill. P&G has doubled its dividend every seven years since 1950.

In considering dividends, there are two diametrically different investment approaches.

On one hand, John Rockefeller was a long-term investor. He could look forward to servants bringing him dividend checks on a silver plate.

On the other hand, in my 35-year trading career, I focused on short-term stock swings. I worked like a dog trying to buy low and sell high. On occasion, my head ended up on the platter.

Originally published in the Sarasota Herald-Tribune