Good Quarterly Earnings are Nice, But Dividends Pay the Bills

Quarterly “earnings season” never fails to consume the full attention of investors. Because companies are required by law to publish financial results every three months, a Balance Sheet (showing assets and debt), Income Statement (showing revenues and expenses), and Statement of Cash Flow (sort of like an Income Statement that strips out a lot of accrual accounting decisions) are reported. Most companies host a conference call to discuss their results and field questions.

Financial analysts always predict what numbers a company will post. As of this writing, over 90% of the S&P 500’s public companies have reported their results for Q1 of 2023. So far, almost 78% of those companies have surpassed the analysts’ profit estimates, posting earnings above what was expected.

Don’t read much into that statistic. Ever since the dot com crash in the early 2000s, public companies have under-promised and over-delivered. In fact, about 73% of companies have surpassed estimates over the last decade.

Many executives will admit (usually after retiring from their position) that quarterly reporting is far too frequent. After all, it often takes years for a wise decision to pan out.

Investors are better off to focus on the long term rather than quarter to quarter fluctuations. In a three-month period, a company could post poor results because of bad weather, an order that took too long to arrive, or a labour strike that disrupted deliveries.

Rather than focus on quarterly earnings, pay closer attention to the dividend income a stock pays its shareholders. Dividends are often overlooked. The cash trickles into your account and you probably don’t even notice the payment arrive (which is usually four times a year… the same frequency as an earnings report).

The existence of a dividend is a major component of a long-term total return. In fact, between 1926 and 2022, dividends accounted for 39% of the total return on the S&P 500. In Q1, a record number of dividends were paid out by companies to shareholders (in case you’re wondering, it was $146.8 billion).

Many simply look at the yield to form their opinion about a dividend. This is the percentage of your investment (at market value) that you receive back each year in cash dividend payments. While important, it is a mistake to look at the yield in isolation.

In addition, here are some of the things we consider as part of our analysis when assessing a dividend.

1. How much of the company’s cash flow is paid out to shareholders in dividends? This is called a “payout ratio.” We never want it to be too high, especially if the business operates in a volatile area where revenues are subject to fluctuation. If the company needs to make investments to maintain or expand their operations, that dividend is likely to get cut if the company needs the money for other purposes. The stock price never likes a dividend cut.

2. Does the company have a history of increasing its dividend over time? Stocks that regularly increase their dividend each year are referred to as “dividend aristocrats.” This is usually a sure sign that you’re dealing with a high-quality company. Investors pay a premium valuation for high quality companies, which means a growing stock price over time.

3. Has the company ever cut its dividend? If so, is the same management still in place and have they learned from the past? Any time a dividend is cut, have a look at how far the stock price fell. If the decline is significant, a large portion of the investor base was invested in the stock for the income component.

While earnings season provides helpful updates, changing an opinion about a company every three months is too frequent. Instead, focus more so on the dividend history to get a better assessment of the quality of your investment.