A number of fund managers have recently pointed out that investors are ignoring a major factor when looking for income.

It’s nice to get those regular dividend cheques (or deposits) every six months, but that means little if the companies can’t grow their earnings and dividends. To grow earnings, companies can retain more of their profits to reinvest back into their business or make acquisitions, but that will mean less left over for shareholders in the form of dividends and a lower payout ratio.

They can also utilise debt to grow their business, but at some stage, companies need to factor in the repayment of that debt, and they can only do that by growing earnings.

In recent years, the big four banks Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) have managed to partly increase their dividends by increasing their payout ratios – but that means less capital left to invest.

It also means that at some stage, the banks will reach a limit where they can’t raise the payout ratio anymore. The problem then is they either have to cut the payout ratio and reduce dividends, or wait for earnings to rise.

Several studies have also shown that companies that can earn high rates of return (on equity) should reinvest all of their profits back into the business, rather than pay out dividends. That can result in a booming share price ala Warren Buffett’s Berkshire Hathaway – which has only paid a dividend once in its history (under Buffett’s ownership).

But there is also a case for companies to pay out dividends…

  • There is an abundance of research showing that high dividend yielding portfolios can produce attractive total returns over long measurement periods, compared to portfolios with lower-yielding securities and the total market.
  • Dividends can make up a significant proportion of returns over the long term, particularly if reinvested.
  • The ability to pay dividends is one factor that can be used to assess the underlying health and quality of a company. That becomes particularly important if the company has complex accounting as well as in regards to fraudulent earnings manipulation.
  • Investors have the ability to utilise dividend reinvestment plans (DRPs) to reinvest their dividends back into the company, and receive more shares when the share price is low compared to when the share price is high. Reinvestment of dividends during periods of market falls has been shown to lessen the time necessary to recoup portfolio losses.
  • If a company is mature and unable to earn a high rate of return on its capital, then it makes more sense to pay out higher levels of dividends. That might only be a temporary hiatus until the company can begin earning higher rates of return on its retained profits again.
  • In Australia and some other countries, the tax treatment of dividends in the hands of shareholders is an advantage to other types of investments, so it makes sense to pay dividends. We have franking credits so we don’t pay a double tax on company profits (Once in the hands of the company, and then again in the hands of the shareholder).

Foolish takeaway

Don’t believe the hype that growth is always better than income. Companies paying out decent dividends should be a core component of most investors’ portfolios.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.