Dividend Yields Should Be a Lot Higher

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Dividend investing has always been popular, but it became an absolute necessity for millions of investors in the low interest rate environment we've seen for years. Yet now that rates on bonds and other fixed-income investments have started to rise, the big question is whether interest in dividend stocks will start to wane.

For income-hungry investors, yields matter most. So for dividend stocks to hold their own in the stocks vs. bonds battle, they'd need to provide bigger payouts. Fortunately, for many companies, boosting the amount of their dividends not only wouldn't be a problem but arguably should already have happened.

Bring on the good news
Microsoft made plenty of dividend investors happy yesterday when it announced its latest dividend increase. The tech giant boosted its payout by 22%, raising its quarterly payout to $0.28 per share and increasing its yield to 3.4%. The move was just the latest in a series of annual increases of 15%, 25%, and 23% that have added up to Microsoft's dividend more than doubling since 2010.

Microsoft's moves have been consistent with what several other blue-chip stocks have done in recent years, especially among tech stocks. Cisco went from paying no dividend at all as recently as early 2011 to nearly tripling its payout in just the past year and a half, bring its yield to 2.8%. IBM has made successive dime-per-share dividend raises for four years running, even though its high share price has still kept its dividend yield limited to about 2%.

Looking at the Dow Jones Industrials on the whole, Dow dividends have climbed by more than 9% over the past year. But that still leaves dividend investors with reason to complain about companies' stinginess on their payouts.

Capacity to pay
Even with the Dow's dividend increases, its overall yield has fallen over the past year. That's because the average has risen at an even faster 13% pace.

But what's more interesting is that even with the increases, the Dow's earnings have risen enough to leave its overall payout ratio almost unchanged. The Dow pays out 38% of its earnings in the form of dividends. Cisco's current dividend amounts to 37% of its earnings, while even after Microsoft's latest increase, its payout ratio will only rise to 43%. IBM has even more capacity to raise, with a payout ratio of just 27%.

The broader market trend hasn't been much more encouraging to dividend investors, as the S&P 500's  payout ratio has risen from 35% a year ago to 41% today. Yet it too has seen yields stagnate as the index has grown faster than its dividend-growth rate.

Should dividends rise further?
For some companies, paying out the majority of their earnings in dividends doesn't make sense. If a company is still growing, it's easier to hold onto retained profits and cash flow rather than paying it to shareholders and having to turn to the credit markets to raise capital.

Yet for the more mature companies in the Dow, that argument is harder to support. Growth prospects are a lot weaker for most of the Dow's industry giants, leaving them with less need for retained capital. A boost in payouts from 38% just to 50% would push the Dow's overall yield to 3.2%, sending it back above the current rate on 10-year Treasuries.

Why buybacks aren't better
The best counterargument against dividends comes from advocates of stock buybacks. Buybacks have the tax advantage of having tax consequences only on those who choose to sell their shares back to the companies involved, compared to dividend-tax rates of up to 20% for shareholders. IBM has historically made huge use of buybacks to raise earnings per share, while Cisco, Microsoft, and other tech companies have benefited from buybacks alleviating some of the upward pressure on share counts due to option grants. But buybacks also give companies responsibility for timing their repurchases, and they've done a notoriously bad job of allocating capital historically.

Investors should advocate for greater payouts on their dividend stocks. Doing so allows income investors to reap more cash from their investments while giving others the flexibility to make their own decisions about whether to reinvest the income they receive into more shares or in other investments.

Bring on the dividends!
Fortunately, some mature companies within the Dow already have demonstrated a commitment to growing dividends over time. To find out more about them, please check out The Motley Fool's brand-new special report, "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so simply click here now and get your copy today.

Tune in to Fool.com for Dan's regular columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

The article Dividend Yields Should Be a Lot Higher originally appeared on Fool.com.

Fool contributor Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and owns shares of IBM and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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