If you've made it this far in the Investing Classroom, you can't have escaped the following: A stock represents an ownership in a business. So let's say we are part owners as well as managers of a business, and when we closed the books on the year, our firm made a $10 million profit. Better yet, we collected all of it in cash. Now the rub--what to do with that cash?

Assuming we don't simply leave it in the corporate checkbook (though some companies certainly do), we've got four choices. We could:

1. Reinvest it in the business
2. Acquire another company
3. Pay down debt
4. Return the cash to shareholders

Real-life boards of directors face this decision in every quarter of every year. While the first three options can be productive uses for cash, the fourth--a reward to shareholders--is a critical part of the investment process. After all, why else would you want to own a stock if you never received a payback on your investment? Stocks are perpetual-life securities--there's no guaranteed payoff at some maturity date like there is with a bond.

In fact, the grandfather of security valuation (a little-known figure named John Burr Williams) defined a stock's value as the present value of future dividends. It's pretty easy to see why this is true. Even though capital gains loom large in most investors' minds, the ability to sell a stock tomorrow for more than was paid today is contingent on that stock eventually returning cash to its owner, whoever that owner might be at the time.

Dividends: The New Fad?

The two components to total return--dividends and capital gains--have two totally different tax treatments. Dividends are immediately taxable. Taxes on capital gains, on the other hand, aren't due until the stock is sold, creating a tax deferral that aids in wealth accumulation. In theory, if the dividend hadn't been declared, the value of that payment would have continued to compound tax-deferred within the company.

This natural, if not downright unavoidable, advantage that capital gains held over dividends was strengthened further by tax policies that favored capital gains over income. For years capital gains had been taxed at only half the rate of regular income, which included wages, bonuses, interest, and (sadly) dividends. For example, in a tax cut passed in 1997, the rate levied against capital gains was capped at 19.8%, while dividends continued to be taxed at rates up to 39.6%. Some wondered why a company would pay dividends at all.

In time, investors and corporate managers responded to the tax incentives and disincentives. With the birth of a new bull market in the early 1980s, dividends came to figure less and less in investors' selection of stocks. Growth, not stability and income, earned a premium valuation, so corporate managers' incentives were to grow earnings (by reinvesting) or, at the very least, buy back stock and thereby grow earnings per share. From August 1982 to August 2000, the S&P 500 rose at a 14.7% annual clip, but dividends gained at only 4.6%. The yield of the market collapsed from over 5% to just over 1%.

In pursuit of growth, however, a lot of businesses allocated capital poorly. The most profitable--and least risky--growth opportunities are those that are well protected by a company's economic moat. Lots of companies are capable of investing within their existing moats, nurturing their core competencies. But the area (size of the business) surrounded by the moat grows only so fast each year, and supporting this growth will typically absorb only a modest portion of annual earnings. 

Relatively few managers prove to be as good at handling the cash left over. The CEO thinks: "If we're this smart when we invest $100 million a year, think how much smarter we'll look if we invest $1 billion!" Earth to CEO: No, you won't. The additional cash would be much better off with shareholders, who could then allocate their capital among all sorts of different businesses, not just whatever the company saw as worthy of investment. But with the tax policy stacked against the payment of dividends and investors demanding growth in any and all possible forms, earnings that should have been paid out were retained, and the money was inevitably wasted.

After the tech and housing bubbles, however, investors' attention has returned to capital allocation and the importance of dividends. Plus, today, the perverse incentive that double-taxing dividends (first as corporate income taxes, then as personal taxes) created for corporate managers is on hiatus due to tax-relief legislation. Dividend yields are still low by historical standards, but dividends seem fated to play a much larger role in market returns in the years to come.

Dividends and Total Returns

During the bull market, the pursuit of rapidly growing businesses obscured the real nature of equity returns. But growth isn't all there is to successful investing; it's just one piece of a larger puzzle.

 
Total return includes not only price appreciation, but income as well. And what causes price appreciation? In strictly theoretical terms, there's only one answer: anticipated dividends. Earnings are just a proxy for dividend-paying power. And dividend potential is not solely driven by growth of the underlying business--in fact, rapid growth in certain capital-intensive businesses can actually be a drag on dividend prospects.

Investors who focus only on sales or earnings growth--or even just the appreciation of the stock price--stand to miss the big picture. In fact, a company that isn't paying a healthy dividend may be setting its shareholders up for an unfortunate fate.

In Jeremy Siegel's The Future for Investors, the market's top professor analyzed the returns of the original S&P 500 companies from the formation of the index in 1957 through the end of 2003. What was the best-performing stock? Was it in color televisions (remember Zenith)? Telecommunications (AT&T)? Groundbreaking pharmaceuticals (Syntex/Roche)? Surely, it must have been a computer stock (IBM)?

None of the above. The best of the best hails not from a hot, rapidly growing industry, but instead from a field that was actually surrendering customers the entire time: cigarette maker Philip Morris, now known as Altria Group (MO). Over Siegel's 46-year time frame, Philip Morris posted total returns of an incredible 19.75% per year.

What was the secret? Credit a one-two punch of high dividends and profitable, moat-protected growth. Philip Morris made some acquisitions over the years, which were generally successful--but the overwhelming majority of its free cash flow was paid out as dividends or used to repurchase shares. As Marlboro gained market share and raised prices, Philip Morris grew the core business at a decent (if uninspiring) rate over the years. But what if the company--listening to the fans of growth and the foes of taxes--attempted to grow the entire business at 19.75% per year? At that rate it would have subsumed the entire U.S. economy by now.

The lesson is that no business can grow faster than the economy indefinitely, but that lack of growth doesn't cap investor returns. Amazingly, by maximizing boring old dividends and share buybacks, a low-growth business can turn out to be the highest total return investment of all time. As Siegel makes abundantly clear, "growth does not equal return." Only profitable growth--in businesses protected by an economic moat--can do that.

DRIPs

If you think dividend-paying stocks might be good for you, you may want to consider participating in a DRIP. DRIP is common shorthand for "dividend reinvestment plan." Not every investor needs dividends for income, so many dividend-paying companies offer the option of automatically reinvesting dividends in additional shares.

Signing up for DRIPs may help you focus on a company's long-term business prospects (because you will presumably participate in a DRIP for a long time), and it also allows investors to benefit from dollar-cost averaging. Many plans even offer a discount to the market price of the shares on the payment date.

You can find out more about a company's DRIP by visiting the investor relations section of its Web site; you can also find out whether a company offers a DRIP or not on Morningstar.com. Participating in a company's DRIP requires having the shares registered in your name (rather than "street name," where your broker is listed as the owner on your behalf), but before starting the paperwork to retitle your stock holdings, you'll want to find out if your broker offers a low-cost or free dividend reinvestment option as well--many of the larger firms do.

The Bottom Line

Traditional-minded investors like us are glad to see dividends making a comeback. Compared with retained earnings or buybacks, a solid dividend establishes a firm intrinsic value for the stock, helps reduce the stock's volatility, and acts as a check on management's capital-allocation practices. Simply put, it's the way things were meant to be.