Ever wonder what makes companies pay a low yield versus a high yield? Why does Visa pay a yield below 1% while AT&T offers nearly 7%? If you want to pick better stocks to secure your retirement income and protect it against inflation, understanding the reasons for low vs. high yield helps.
When we receive money, we don’t always care to understand where it’s coming from or why; we’d rather think about what we’ll do with it. Much more fun. But let’s dig into this a bit. Dividends aren’t magic money deposited into your account. Why does a company pay you a dividend in the first place?
The dividend mechanic
Some will say that companies pay dividend to reward shareholders and provide them with income, to signal their financial health, or to attract investors. Others will say it’s to give themselves a competitive advantage or to force themselves to be disciplined in their decisions for allocating capital, or other reasons.
Fundamentally though, a company pays a dividend when it is unable or unwilling to use that money create even more value for shareholders. In other words, the company would rather pay you $1 in dividend when it cannot find a good project in which to invest that same dollar.
Imagine a management team that has considered marketing spending, research & development, expansion by acquiring other companies, hiring talent, etc., and they just couldn’t find anything that was worth the investment. Therefore, they transfer that responsibility into your hands and call that a “dividend”. You, as a shareholder, now have the responsibility to allocate that dollar and find a better investment.
Logically, a company paying a low yield is likely to show a lower payout ratio because the business is growing so quickly; and its management is able to find plenty of projects to generate value for shareholders, i.e., to increase the stock price. The dividend mechanic is a simple money transfer from one bank account to another.
Get in-depth information on how low yield stocks contribute to dividend income. Download our Dividend Income for Life guide.
Why companies pay a low yield
Low-yield, high-growth stocks show a strong ability to grow their sales and are even better at growing their profits. They enjoy strong growth vectors and are also able to expand their margins along the way. Perhaps because they are in a rapidly expanding industry with demand growing be leaps and bounds (think mobile phones from 2003-2018), or because they are innovators who are constantly a step ahead of the rest of the field (think Microsoft circa 2017-2021), or they excel at growing their business either through acquisitions or by expanding in other products or markets.
In other words, they are growth stocks that happen to pay a dividend. The dividend they pay is small because the companies are growing very fast, often at double-digit growth rates, and because they regularly use a sizeable portion of their income to fuel their growth.
However, the past is never a guarantee of the future. At one point, low-yield, high-growth stocks will either become mature businesses or find other growth vectors that will bring them right back on the fast track.
Why companies pay a high yield
Companies paying a high yield are often mature businesses with less growth potential. Why? They could be in an industry where the market is saturated, and demand has peaked without much room to grow other than by grabbing market share from competitors.
Some try to make moves to generate growth, but it doesn’t always work. AT&T completely failed in its attempt to expand into the media & entertainment industry and ended up cutting its dividend and spinning-off its media segment. A success story is Broadcom (AVGO), the multinational semiconductor and technology company that managed to sustain its growth with many acquisitions, expanding into different geographical markets and diversifying its product portfolio.
Unfortunately, the line is often thin between being a mature company generating growing cash flow that enables a minimum of dividend increases, and one that’s increasingly struggling, eventually cutting its dividend. IBM is an example of high yielder arriving at that crossroad.
IBM’s inability to find growth has already weighed in on its ability to generate more profit and starts to weigh on its ability to grow its dividend. We often reach this conclusion for higher yielding stocks: they once were great companies that are now, or might be, marginal companies.
Get in-depth information on how low yield stocks contribute to dividend income. Download our Dividend Income for Life guide.
There is magic with dividends
The magic happens when you find dividend growers. Dividend growers are companies that can increase their dividend every year. To maintain this, dividend growers must be able to grow their sales and profit year after year.
Who wouldn’t want to invest in a company growing its sales and profit? Dividend growth is the result of a great company with a great business model and a robust balance sheet.
Unfortunately, we find fewer of these amazing companies amongst high yielders. Low-yield, high-growth stocks don’t have the monopoly on being great companies, but there are many more great companies amongst the low yield, high growth stocks.
So why in the world do many retirees tend to ignore them?
[…] Yield – The yield is important to some types of investors; income-seeking investors will probably discard a stock with a very low yield. Dividend growth investors won’t necessarily mind a low yield, as long as there’s consistent growth. […]