Why Dividends Beat P/E Ratios - TheStreet

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

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) - Get Report

, which trades at 6 times forward earnings, or

Arcelor Mittal

(MT) - Get Report

, 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.

Dividends are also valuable in another way which may highlight one of their most underrated advantages. Dividends promote operational efficiency. Executives are well aware of how important a dividend payout is to both existing and potential shareholders. They also know what a suspension or reduction of the dividend can do to the stock price. Maintaining the dividend promotes good corporate stewardship of the business.

Finally, and most crucially, a continued dividend payments reflects confidence that a business can continue earn and grow profits, which is where the money will flow to when market confidence finally resumes.

So when you hear investors promoting the advantages of dividends, understand that they go beyond the additional monetary value you receive from your investment. To be sure, you want companies that are very capable of paying the dividend in addition to growing the business. What good is a 7% dividend if it goes away next quarter? Similarly, what good is a 7% dividend if the stock price declines by 50%?

Keeping this in mind, the market today is serving up some amazing dividend plays that won't last long. When money starts coming back into the markets, one of the first places it will go to will be into stocks that have juicy dividend yields.

Some easy places to look would be

Johnson & Johnson

(JNJ) - Get Report

, a company with unlimited growth potential. JNJ has increased its dividend every year for decades and currently yields 3.4% at today's price of $58.

Kraft Foods

(KFT)

pays you 4.4% and counts

Berkshire Hathaway

(BRK.A) - Get Report

as its largest shareholder.

Altria

(MO) - Get Report

, formerly Phillip Morris, historically one of the most dependable dividend payers, now yields over 8%. All three are wonderful safe plays that many large funds will jump into when the market turns.

Another area of excellent dividend payouts is the energy sector, specifically energy master limited partnerships. Roughly speaking, they are like the equivalent of real estate investment trusts, but for the energy sector. Energy MLPs acquire mature stable reserve assets, sell them and pay out their cash flows as dividends. My favorite, which I have written about a number of times, is

Linn Energy

(LINE)

, which currently yields 21% because the stock price has slipped over the past few days along with the market.

TheStreet.com TV: In Dividends We Trust?

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Normally, a 21% yield is an indication that the market believes the payout is unsustainable. So far, this hasn't been the case. Last month, Linn confirmed the dividend payout, and it should be in fine shape to continue to do so. Linn currently has 100% of its production hedged for 2009 and 2010 (and nearly 100% for 2011) at oil prices of around $80 and natural gas of $8. Production level should continue to slowly increase, and the company has done a marvelous job of monetizing assets in this restricted environment.

Recently it announced a $100 million unit buyback, a prudent move given the decline in unit price. Buying back units at these prices is a very smart use of capital. It makes more sense to retire equity paying 20% than debt at 8%.

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Currently, markets are serving up amazing yields for a limited time only from some of the most respectable businesses in the world. Sooner or later, they will be noticed, and that means additional investors will increase the stock price, creating a double benefit for those who are willing to go in now.

This was originally published on

RealMoney

on Nov. 26, 2008. For more information about subscribing to

RealMoney,

please click here.

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

sham@gadcapital.com

.