There is an ongoing debate between investors and analysts about the importance of earnings, specifically the metric of Earnings Per Share (EPS), and Dividends per Share (DPS). The key question when analysing common stocks is, which is more important?
The above question can be fleshed out more fully as: are the earnings of a company, or the dividends paid by a company more important in regards to two key issues: a) the inherent strength of the company, and b) the future price action of its stock.
Broadly speaking, there are currently two schools of thought. First, what I might term the classic Value Investing School pioneered by Graham, Dodds and Buffett. The classic approach places the ‘earnings power’ of the company as the key fact which impacts the ‘intrinsic value’ of the company. The intrinsic value is a measure of the company’s stock price derived from a number of key metrics, the most important of which is earnings, specifically Earnings per Share (EPS). For classic value investors, EPS is the prime consideration. Dividends or DPS are secondary. In some cases, it is preferred the company not pay any dividends at all. It is preferred that surplus earnings are reinvested to further grow the company, either by natural expansion or acquisition. In this way, the metric of Retained Earnings (RE), which is simply EPS minus DPS is something to keep a close eye on.
The second school, which I might term the Modern School, believes EPS is important, but dividends are just as important, and often more important. The logic here is, if a company can show consistent dividends over time, and importantly, can show recent growth in dividend pay-outs, then this must reflect an inherent strength of the company. The Modern School does not necessarily accept it is more important to re-invest surplus profits for future growth.
Deciding which is right, or which is right for you is a very important threshold question all investors and analysts must face. For example, if you are of the Modern School and a company pays sound dividends, yet it has uneven or low earnings over time, then this will influence your decision-making quite differently compared to the classic Value Investor.
Your strategy will naturally also be important. Value Investors are usually searching for ‘growth stocks’. They looking for capital gains through growth of the stock price. They believe the stock price will grow if the company is inherently strong. A company is inherently strong if it has a solid EPS history, and usually a low payment of dividends because surplus earnings are re-invested to achieve future growth of the company and its future earnings.
On the other hand, Yield Investors usually fall into the Modern School. They are chasing dividend yield. Yield Investors are usually income focused, not capital gain focused. Retirees commonly fall into this camp.
The insight I would like to share is: why is it necessarily either-or? A company that has a strong earnings history, and a strong dividend pay-out history, may be a very attractive company. It might have inherent strength that can provide future growth in both the stock price and in future dividend payments. These companies are rare, but they do exist. They can be simply found by carefully studying the EPS and DPS histories for at least five, preferably ten years.
There is one caveat here. We cannot always have our cake and eat it. At the end of the day, dividends come from earnings, so earnings, or the EPS metric must be the superior metric, especially where there is a conflict between EPS and DPS. What we need to be careful of is seeing a company trying to entice investors with infrequent high dividend pay-outs that are not coming from strong earnings, often coming from debt. This is not sustainable, and does not point to an inherent strength in the company.
We trust this short article has focused your mind on some important differences between earnings and dividends. Many investors and analysts often gloss over them, or fail to appreciate their linkages. As with all things in investing, there is no one metric or tool that can ‘predict’ anything. Our decision-making should be based on probability. And probability thinking should always be guided by solid principles and evidence from objective data. How we interpret and use the data, here in the case of earnings and dividends, is crucial for consistency and getting a deeper understanding of the company and its management. I trust these insights will give both the investor and analyst a stronger footing for long term success.
Lee Spano, Founder & CEO
Creatness International, www.creatness.com
© Copyright Lee Spano. All rights reserved.