Yield vs Returns: Why You Shouldn’t Prioritize Dividends That Much

Passive income.

High yields.

Consistent dividends.

The terms above describe common investment goals, particularly for older and retired Canadians. Such investors want to get dividend income from their investments, because dividends are seen as more “reliable” than capital gains. That perception is probably true to an extent. Most companies pay the same dividend for an entire year, while stock prices swing around violently in mere days.

Despite this, the relationship between dividends and total returns is not clear. Research finds that high yields do not predict high total returns, while dividend growth does predict outperformance. So, the mere fact of a stock paying a dividend doesn’t mean it’s going to give a high return. It’s dividend growth – or the fundamental performance powering dividend growth – that matters.

It’s easy to think of cases where ‘needing’ dividends would have deprived investors of excellent returns; for example, Berkshire Hathaway since 1965, or Alphabet/Google from its IPO until last year. Both of these stocks delivered excellent returns in the time periods specified, despite not paying dividends. Why is this the case?

Dividend irrelevance theory

There is actually quite a bit of academic research attempting to explain the contribution of dividends to total returns. Some theories posit that dividends correlate positively with returns, but the most popular theory holds that dividends are immaterial. This theory is called the dividend irrelevance theory. According to this theory, stock prices reflect underlying intrinsic value at all times, so if a stock pays a dividend, its stock price will simply decline by the amount of the dividend when it is paid (or rather, declared).

This theory makes some sense. Stocks are bits of companies, and the more a company invests back into itself, the more it should be worth – at least if the investments it makes are good ones.

Still, questions can be asked about whether a company’s stock should reflect its underlying value. If a stock never pays a dividend, then how do minority shareholders access the underlying assets? It’s a question worth asking. So, let’s explore how companies can put their wealth back into shareholders’ hands.

The magic of buybacks

Buybacks is one way companies can deliver value to shareholders, without paying dividends. If management thinks its stock is undervalued, it can buy back it back until intrinsic value is achieved. Buying stock creates demand, so buybacks tend to increase stock prices. A buyback is therefore one mechanism by which corporate fundamentals influence stock prices.

The expectation of future dividends and buybacks is another one. If investors think that a company is going to do a buyback in the future, they may hold the company’s stock in anticipation of the payout. If they are right, then they’ll likely get a capital gain in the future.

The power of dividends and buybacks illustrated

A great stock for illustrating the comparative value of dividends and buybacks is The Toronto-Dominion Bank (TSX:TD). Year to date, the bank has paid out $7.5 billion worth of dividends and completed $15 billion worth of buybacks. TD stock was pretty cheap at the beginning of the year, having a near-6% yield at that time. An investor who bought the stock back in January would have earned a lot in dividends. However, they’d have gotten far more in capital gains.

As you can see in the image below, TD stock has risen 67% in price so far this year. It has also delivered a 73% total return with dividends re-invested. The vast majority of the year’s return was from capital gains, not dividends. And since TD’s buyback was more than 10% of the beginning-of-year market cap, said buyback was probably a big influence on the capital gain.

The lesson here is obvious: dividends aren’t everything. Even in high yield stocks like TD, capital gains usually deliver the majority of the return. So, don’t sweat the yield too much. There are more important things to think about.

The post Yield vs Returns: Why You Shouldn’t Prioritize Dividends That Much appeared first on The Motley Fool Canada.

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More reading

• This Canadian Bank Stock Could Be the Best Buy in December
• Top 3 Dividend Stocks to Buy Before the Year Runs Out
• TD Bank Stock is Up a Remarkable 68% in 1 Year: Is it a Buy?
• This Recession-Resistant TSX Stock Can Last for a Lifetime in a TFSA
• Got $500? These 2 TSX Value Plays Are Too Affordable to Ignore

Fool contributor Andrew Button has positions in Toronto-Dominion Bank, Alphabet, and Berkshire Hathaway. The Motley Fool recommends Alphabet and Berkshire Hathaway. The Motley Fool has a disclosure policy.