Comparing dividend paying tech stocks to non payers

Sunday afternoon Matt told me that when it comes to tech stocks, he prefers companies that pay dividends. I agree because a higher than average dividend yield can be an indicator that a stock has value. Dividend payments, if they are stable and growing, can only come from a healthy business that produces reliable profits.

Examples of tech companies that have consistently made and increased payments include Microsoft, Intel, IBM, Cisco, and Apple. Alternatively, Facebook, Google, Amazon, and Netflix are examples of companies in that space that don't pay dividends because they are growing so fast that they use all their cash to reinvest in more growth opportunities.

Generally speaking, all of the companies listed above generate tons of "free cash flow" because of their sky high profit margins and ability to run their businesses without constantly investing in additional plant and equipment and physical inventory. The major difference between the dividend paying and non dividend paying groups is their maturity. A decade or more ago, the first group was growing like the second, and therefore using all of their FCF to reinvest in their opportunities, and none of it for dividend payments. Because these companies have captured such huge market shares in spaces that after long periods of growth have now slowed down, they now are sending payments to their investors. The latter group consists of younger companies that are solving newer problems and growing faster. One day, if they survive, they will be dividend payers too.

Another general distinction between the two groups of companies is the price-to-earnings ratios of the companies' stocks:

Just like a higher than average dividend yield can be evidence that a company's stock is not over priced, a reasonable P/E ratio, when compared to other investment opportunities, can provide an investor with some confidence that a "margin of safety" exists in these stocks.

Hours after our conversation Sunday, this feature about tech stocks that pay dividends was posted at WSJ.com. The article explores whether dividend paying tech stocks like those mentioned above have been over priced in what recently has been called a "search for yield" among investors turned off by historically low yields in the investment grade bond market. The article makes a key point that although the yields are attractive, there is always the risk that over short periods of time, the price fluctuations in the stocks may not be suited for investors with an immediate need to sell. But this consideration holds for not just dividend paying tech stocks, but all investments that aren't very short term, high quality bonds. Another solid point is that certain companies may not be able to sustain high dividend yields because their long term profits won't support them. Again, this is an always present concern for all investments (the "we can't predict the future" problem) that can only be addressed by doing research to reduce the risk of making too many errors, and, more importantly, buying many companies in the space to guard against putting too many eggs in the basket of those that do eventually fail.

But the most notable part of the article, which provides a clue to the missing piece in my comparisons above and helps answer the more important question of whether these dividend paying tech stocks are reasonably priced in the larger investment market (not only compared to the fastest growing tech stocks), and in relationship to how, historically, they have been priced in relation to that broader market, is this set of lines:

Along with some other homework, applying these same comparisons to the other dividend paying tech stocks can add confidence to our (Matt and my) beliefs that despite their strong recent performance, these are still reasonably priced investment opportunities.

Disclosure: I am not an investment professional and I don't write posts like these to suggest that readers buy specific stocks or do anything in particular with their specific financial plans. I don't know the specific details of readers' situations and needs, so they should take responsibility for their own financial decisions. I do currently own many of the stocks mentioned in this post.

***Special note: If you ever click on a link to a Wall Street Journal article and are denied access because you are not a paying subscriber, you can type the title of the article into Google and get a link to that article that is not protected behind a pay wall.***