The Future of Dividends

Posted on October 7, 2010 by David Laidlaw 

For the first time since the early 1960s, the S&P 500 yield is comparable to the 10-year treasury yield.  The yield on the S&P 500 is currently about 2%.  The 10-year treasury is now yielding about 2.5%.  The ratio between these yields is as high as it’s been since 1962. Both 1960 and 1961 ended with the S&P 500 yielding more than the 10 year treasury.

Are we entering a new period where dividends yields are higher than interest rates?  Not likely, unless interest rates get even lower.  The current relative strength of dividends is more due to the extremely low interest rates and general depression in stock valuations (i.e. P/E ratios) than companies increasing their dividends.  The payout ratio (percent of earnings paid as dividends) has fallen pretty steadily since the 1960s when it was about 60%.  Before the market crash in 2008 it fell below 30%.

The payout ratio has jumped the last couple years as earnings have fallen, but companies have not proportionally cut their dividends in order to improve their financial strength.  As earnings increase, companies are unlikely to increase their dividends.  They are also unlikely to react to increasing interest rates. 

Investors have come to expect lower payout ratios and companies will not feel the pressure to increase them.  Increased payout ratios can hurt the perception of a company- if a company pays more in dividends it’s investing less in growth opportunities.  The company is essentially admitting it has limited growth potential, which means a lower P/E ratio and ultimately a lower stock price.  Even if a CEO could increase a company’s payout ratio without hurting its investing opportunities, no company will actively try and decrease its multiple. 

This interpretation of dividend incentives means payout ratios are going to remain low.  The most likely scenario for increased yields is lower P/E ratios, caused by a negative market outlook, which will decrease stock prices but increase yields.  The current relative strength of dividends is due to low interest rates and slightly depressed stock valuations, not a general reversal in how companies formulate their dividend policies.