Why Dividends Beat P/E Ratios

We all know the fundamental benefits of dividends to long-term results: They add up and over the years translate into significant differences in returns. However, the benefit of a dividend payment goes even further, and a market like the current one makes this clear.

Over the next few years, investors would be very wise to look at dividend payouts and assign them a greater degree of importance than P/E ratios.

Why? Many price-to-earnings ratios appear to be well below historical averages on a forward-looking basis. Relying heavily on P/Es going forward may not be such a smart idea in an environment where earnings are in constant danger of being revised downward.

Just look at Goldman Sachs (GS - commentary - Cramer's Take), which trades at 6 times forward earnings, or Arcelor Mittal (MT - commentary - Cramer's Take), which trades at 4 times forward earnings. Such "cheap" valuations have done nothing for investors. If you bought Mittal at 8 times earnings, you're down over 75% on your investment today. In all fairness, strong businesses like Mittal and Goldman will rally powerfully when the market gets its appetite back, but that's no consolation if you're already down 50% on your investment.

Dividends, on the other hand, are a much more reliable indicator of future performance because they are a great indicator of operating performance. Short-term earnings numbers can be massaged to hide the true picture. Dividends cannot. They are real, tangible cash payments that have to be made. Debt payments have to be made prior to dividend payments; if a company is having trouble making debt payments, the earnings picture might not reveal it until it's too late. However, a company's dividend policy can't be hidden or massaged.

Dividend cuts can alert you to the fact that something is not right in the capital structure. Many businesses benefit tremendously by paying a dividend. A lot of investment funds won't even look a business if it's not paying a dividend, so eliminating a dividend payment can take a lot of potential money off the table. CEOs try their hardest to continue paying out dividends, and if the house is not kept in order and the dividend is cut, they can't hide that from investors.

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At the time of publication, Gad was long Berkshire Hathaway and Linn Energy, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund and the Gad Partners Offshore fund, value-centric investment partnerships based in Athens, Georgia. Gad has written extensively for the Motley Fool and was a securities analyst for UAS Asset Management, a small, value-focused fund in New York City in 2007. Previously, Gad managed assets for the Gad Investment Group. For additional information, please visit www.gadcapital.com.

Gad also runs a value-investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Additionally, he is currently working on a value investing book to be published by John Wiley & Sons in the fall of 2009. Gad earned his BBA and MBA at the University of Georgia. Send Sham Gad an email. You can reach Gad at [e-mail].