For the past week here on Seeking Alpha, there has been an article floating around that's generated a lot of buzz about Warren Buffett's decision to not pay dividends to Berkshire Hathaway (BRK.A) shareholders. (You can find the original article here.)
The article is presented from the point of view of a retiree or anyone looking to generate recurring payments from their investments. To summarize, the author (The Part-Time Investor) presents a model that suggests that if Berkshire Hathaway paid quarterly dividends of 1% of its stock price, retired investors would be significantly better off than if they had to sell a portion of their shares each quarter in order to generate income.
I'd suggest reading the original article for more context on the points made in his argument, but here I'd like to hone in on what I think is the biggest flaw with this line of thinking (one shared by many dividend advocates) and that is this: that there is no opportunity cost associated with a company paying dividends.
Allow me to explain. Assuming that a company has a steady stream of opportunities for investment (i.e. capital projects, acquisitions, new product lines, etc.), if a company pays dividends, they now have less capital to invest in these opportunities that will build long-term value. In reality, many companies are too large to find these types of opportunities and because of it, they pay out their excess capital to shareholders each quarter in the form of dividends. However, Berkshire's diversity frees it from the constraints most companies have. Mature car companies like Ford (F) or General Motors (GM) only have so much room to expand (think about how many people do you know that don't own a car), so they return a significant of their annual EPS to shareholders. Berkshire still regularly finds opportunities to grow, however, because they can expand into completely unrelated industries (see Geico and BNSF) if the price is right.
Conservatively, the opportunity cost to Berkshire for paying its investors dividends rather than investing in acquisitions or projects is 15%, which is great by the way. And as long as they continue to prove to me that they can consistently generate those kinds of returns, I'll never ask them to pay out a dividend.
If Berkshire had paid dividends over the past 24 years (the time horizon used by the author in the article linked above), its book value per share would be nowhere near where it is today and as a result, neither would its stock price. In order to demonstrate my point, I ran my own model based on the past 5 years' worth of data (3/3/2009-12/31/13) from Berkshire Hathaway. Here are the parameters of the model that I made:
1. A retiree owns 100 shares of BRK.A stock and wants to generate a quarterly income. The two options he has are:
a) to receive a quarterly dividend equal to 1% of the book value of equity (see more on this dividend assumption in point 3) or
b) to sell shares every quarter to generate the same amount of income that he would've received from the dividends.
2. BRK.A's quarterly return on equity (ROE) would remain the same for every quarter in the past, regardless of whether or not dividends would be paid. Over the past 5 years, BRK.A has generated an average quarterly ROE of about 3.7%.
3. The quarterly dividends of 1% of the book value per share would reduce the book value of equity. This isn't actually an assumption since dividends really do reduce a company's amount of retained earnings (and thus, book value per share), but it probably needs to be brought to mind in order for the calculation to make sense.
It should be noted that this is different than the other author's assumption of a 1% of stock price quarterly dividend. However, a company basing their dividend on their book value of equity seemed like a more realistic scenario than basing it on their stock price, which is a constantly moving target.
4. The intrinsic value of BRK.A can roughly be determined by its book value of equity. Over the past 5 years, Berkshire has averaged a price to book ratio of 1.25 with the range fluctuating from 1.11 to 1.40 during that time.
The hypothetical stock prices/intrinsic value when dividends were paid would be based on the actual price to book ratio that the market priced into the stock at the time that the hypothetical dividends were paid. For example, if the market priced BRK.A with a price to book ratio of 1.23 on 12/31/2012 (which it did), then the market would still price BRK.A at a price to book ratio of 1.23 at that date even though it was paying dividends.
5. Fractional shares could be sold in order to generate a quarterly income exactly equal to receiving a 1% of book value quarterly dividend. This is actually pretty reasonable to assume because if the hypothetical retiree converted all of his BRK.A shares to BRK.B shares, it would multiply his original number of shares by 1,500. This would bring his share total to 150,000, making it much easier to sell a whole number of shares and still receive a pretty precise amount of income (at the worst, within about $100 of the amount he actually wanted to receive).
With these assumptions in mind, I went to work comparing the two scenarios presented in point 1. Check out the findings below:
1. With both scenarios, the retiree generated a cumulative amount of $1,810,167 in income over the 5 years observed. In the dividends scenario, the retiree maintained all 100 of his original shares. In the stock selling scenario, however, the retiree only had about 86 shares left after the 5 years due to the selling of shares to keep up with the dividends paid in the other scenario.
The difference in the amount of shares is pretty nominal, however, because as the stock price increases, fewer shares would have to be sold to maintain the same amount of income. Also, if the stock price reached too high, Berkshire may form a new class of shares that could be converted from class A or B shares that would give a retiree a higher number of shares and more flexibility in how many shares he had to sell.
2. The 12/31/31 closing stock price of BRK.A in the dividends scenario was $145,506 compared to the actual closing stock price used in the share selling scenario of $177,900 (a 22.3% difference).
So, why is this? Well, the answer goes back to my original point at the beginning of the article. Because Berkshire paid dividends every quarter, they had a smaller equity base to provide returns on for its shareholders. In other words, even though the ROE (Earnings Per Share/Book Value of Equity) remained constant, the book value of equity decreased every quarter due to the dividends paid and as a result, EPS was lower every quarter than the EPS from the share selling scenario.
It is a crucial mistake to assume that the only effect dividends would have on Berkshire's stock price would be a temporary drop in value around the ex-dividend date. None of the dividends paid would help Berkshire's book value of equity grow at the rate of every subsequent quarter's ROE. Because of this, the book value of equity in our model was 22.3% higher in the share selling model than the dividends model and this caused the same percentage difference in the stock price.
3. That brings me to a curious point from the results of my model: the ending portfolio value of $15,192,132 from the stock selling scenario is actually about 4.5% higher than the $14,550,564 ending portfolio value from the dividends scenario. This difference didn't really make sense at first because one would think that an investor would be indifferent to the way in which they receive their income. It shouldn't matter to them whether it's in the form of a dividend or proceeds from the sale of shares as long as they are taxed at the same rate (which for individuals, capital gains and qualified dividends currently are). So, why the difference in portfolio value?
Well, the answer is a little complicated. My model values the hypothetical stock price when dividends are paid as the book value per share multiplied by the price to book value that the market priced actually priced into BRK.A at the end of every quarter over the past 5 years. Because of this, whenever a dividend is paid, its effect on the stock price is actually amplified by the price to book ratio. If the price to book ratio was exactly 1, this difference would not exist. And in fact, if the price to book ratio was less than 1, the dividend scenario would produce a greater ending portfolio value than the share selling scenario. Due to BRK.A having very strong price support at 1.2x book value because of its buyback program though, I would lean toward saying that this difference will almost always favor a scenario where dividends are not paid.
Would this difference exist in reality? It's hard to say since the market would likely adjust the price to book value whenever a dividend gets paid. It is something to keep in mind though.
What does it all mean?
Looking at the bottom line, what does this mean for somebody that's looking to build a stable income?
Don't be scared away from investing in a company like Berkshire just because they don't pay a dividend. Dividends can be a great tool for companies that no longer have enough opportunities for investment that can generate a sufficient return. Conversely, not paying dividends can be an indicator of a healthy company whose management believes it still has plenty of opportunities for growth.
For generating a stable income, an investor should be indifferent to either selling shares or receiving dividends. It may be easy to have a company decide what your dividend should be each quarter, but it's just as easy to create your own dividend if the company doesn't pay them by selling shares.
To do this, a good place to start would be gathering the quarterly EPS over the past few years for your company and analyst estimates for future EPS over the near term. If earnings are stable or increasing each quarter (a quality which good investments should almost always have), try shooting for a dividend payout of around 25% of EPS and sell enough shares each quarter to meet this target. For example, if EPS this quarter was $4/share, sell enough stock to generate a dividend equivalent to $1/share. As a caveat, I would only encourage this strategy for companies with low volatility and stable price to book or price to earnings ratios.
It should be important to note that I'm also not advocating against investing in companies that pay dividends. I'm just indifferent to it. In fact, if you're not looking for a stable income, but you still own stocks that pay dividends, I'd encourage reinvesting your dividends to purchase more shares (an option that most brokerage firms can easily accommodate). This would help compound those returns that may otherwise get spent or just sit as cash in your investment account.
Thanks for taking the time to read my article and let me know if you have any questions in the comment section below!