Dividend Yields

MANY COMPANIES DON’T pay dividends, so looking at dividend yields won’t necessarily tell you whether one stock is better value than another. But dividend yields can be useful in gauging how expensive the overall market is.

The S&P 500’s dividend yield has been trending lower since 1982’s market trough, though it isn’t simply because of rising share prices. Rather, part of the reason is that companies have instead been using their spare cash to buy back their own shares. Historically, total shares outstanding have grown almost every year, as employees exercise stock options and companies issue new shares to raise cash or finance acquisitions. But that’s changed in recent decades: Corporations have become big buyers of their own stock, and these share buybacks have offset new issuance.

Buybacks are seen as a more tax-efficient way of returning money to shareholders, because the money is used to cash out investors who want to depart without saddling remaining shareholders with taxable dividends. Buybacks may also reflect the current century’s slow-growth economy. With fewer chances for profitable expansion, some companies have decided instead to use spare cash to repurchase shares.

Trouble is, companies appear to be terrible market timers. For instance, they aggressively bought back their own shares ahead of the 2007 stock market peak, but slashed their buying during the market slump that followed. Similarly, they repurchased shares aggressively during the 2009-20 bull market, but many companies quit buying their own stock amid 2020’s and 2022’s market downturns, as they sought to conserve cash. It seems buybacks are driven less by companies’ belief that their shares are undervalued and more by a desire to offset the dilution caused by employees exercising stock options. The latter is more likely to happen during buoyant markets, as the options gain value along with rising share prices.

Indeed, dividends appear to be a surer thing than buyback programs because companies are loath to cut their dividend. Knowing they have to pay a regular dividend can also be a healthy discipline for management, forcing them to be more careful in handling the company’s cash.

Meanwhile, for investors, dividend-paying stocks can provide a fairly reliable and growing stream of income—one that’s arguably superior to that generated by bonds and cash investments. Most bonds generate a fixed stream of interest, leaving investors vulnerable to inflation, while the income from cash investments can fluctuate wildly from year to year, along with changing short-term interest rates. By contrast, over the decades, the dividends paid by the S&P 500 companies have grown comfortably faster than the inflation rate.

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