Historical Perspective: Dividends and Earnings

We have had great success with our dividend-based strategies.

Dividend Sound Bite

Central to any dividend-based strategy is assessing the quality of dividends. Critical to assessing the quality of dividends is assessing the quality of earnings.

I have extracted the following from Chapter 12 of the 4th revised edition (the fifth version) of The Intelligent Investor by Benjamin Graham.

From page 165: “This chapter will begin with two pieces of advice to the investor that cannot avoid being contradictory in their implications. The first is: Don’t take a single year’s earnings seriously. The second is: If you do pay attention to short-term earnings, look out for booby traps in the per-share figures.”

From page 172: “In former times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past—usually from seven to ten years. This “mean figure” was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company’s earnings power than the results of the latest year alone. One important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits. They should be included in the average earnings.”

Also from page 172: “It is of prime importance that the growth factor in a company’s record be taken adequately into account. Where the growth has been large the recent earnings will be well above the seven- or ten-year average, and analysts may deem these long-term figures irrelevant. This need not be the case. The earnings can be given in terms both of the average and the latest figure. We suggest that the growth rate itself be calculated by comparing the average of the last three years with the corresponding figures ten years earlier.”

This is the kind of rationale that led Professor Robert Shiller to report P/E10, where P is the current (real) price of the S&P500 index and E10 is the average of the most recent, ten-year trailing average of (real) earnings. Our success when using P/E10 (and its inverse, the percentage earnings yield, 100E10/P) speaks volumes about its soundness.

Dividends are paid out of earnings. The ten-year average of earnings lets you know whether dividends can be sustained or whether they are in danger of being cut. The growth of earnings lets you know whether to expect a growth in dividends.

Looking at the Dividend Discount Model and its variants:

Investment Return = Dividend Yield + Dividend Growth Rate.

Benjamin Graham tells us about the earnings and the earnings growth rate. They provide the foundation for using this formula.

We have added our own observations about today’s payout ratio and what it means. Because most stocks, even the high dividend payers among high quality companies, have a very low payout ratio by historical standards, today’s dividends are more secure than in the past.

As always, we need to be extra careful when it comes to individual companies.

Have fun.

John Walter Russell
January 25, 2006