Do Low Dividend Yields Still Mean What They Used To?

Chart of the Week for February 18-24, 2000

From 1926 through 1990, the average annual return of the S&P 500 Index was 10.1%. Just over half of this gain came from capital appreciation (the upward change in stock prices) and just under half came from dividends.* Since 1990, this has not been the case. As the chart above shows, dividend yields have continued to decline as stock prices persist in their seemingly boundless ascent. From 1991 through the end of 1999, capital appreciation accounted for nearly nine-tenths of the return of the S&P 500 Index. Dividend income is now perceived by many investors to be of marginal importance. What’s going on?

Typically, low dividend yields have gone hand-in-hand with low inflation, a low interest rate environment, and general investor enthusiasm. Low yields could also be seen as an indication of an overheated market and imminent correction. However, there may be other viable reasons for yields being at an all-time low.

Publicly traded companies have several choices when it comes to deploying corporate profits. They can reinvest the profits back into the business, they can engage in stock buy-back programs, or they can distribute dividends. Investors had historically been keen on dividends because they’re an excellent way to generate income regardless of how the stock is performing.

Reinvesting profits in order to grow the business and thus earnings usually leads to a higher share price. In fact, some investors may prefer this because capital gains are taxed at a lower rate than dividends which are taxed as ordinary income. By engaging in stock buybacks, the total number of shares is reduced and, as a result, stated earnings per share will be higher, which typically results in higher stock prices. This is a plus not only for shareholders but for management. whose compensation is more and more often tied to stock performance. In conclusion, the dividend paradigm may no longer hold true.

Dividends are reported on a per share basis (total amount of the distribution divided by the number of shares outstanding) and commonly paid out on a quarterly basis. Dividend yield is the annual dividend divided by the market price of the stock.

* Source: Ibbotson Associates

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