- A dividend in itself is neither positive nor negative. It depends on the individual circumstances, whether a dividend adds or reduces shareholder value.
- Initiating a dividend can add or reduce shareholder value and the same applies to dividend cuts.
- The best way to understand the consequences of a changing dividend policy is a strict focus on intrinsic value.
My recent article "Rich and Retired? Don't Buy Dividend Stocks" has caused some stir among the Seeking Alpha community, especially among dividend growth investors. Several fellow authors have provided their contributions to the subject, and hundreds of comments have been written.
Therefore I believe it makes sense to sum up the pros and cons of dividends and maybe add some clarity to the discussion.
One major misunderstanding related to dividends is that it's always good to get one, and if a company increases its dividend, the move must be awarded with a higher share price. Conversely, most people believe that cutting dividends should be punished with lower share prices.
However, a dividend in itself is neither positive nor negative. From a totally rational point of view, a dividend doesn't give to a shareholder anything that he did not already have before. It depends on the individual circumstances, whether a dividend adds or reduces shareholder value, whether cutting it is a positive or a negative for the stock price.
Here are a few examples:
1. When initiating a dividend adds shareholder value
Everybody knows about Apple (NASDAQ:AAPL) and its cash hoard sitting in bank accounts and earning nothing. When Apple decided to buy back its own stock and initiated a dividend, the move clearly added value. In other words, Apple is now worth more than before, just because it decided to give some of its money back to shareholders. I assume that few people would ever dispute this, but this doesn't mean they all have the same reason to be happy with Apple's decision. In my opinion, the decision added value to the business, because it removed at least some of the concerns about the company squandering its cash on senseless acquisitions and enhanced shareholders' returns on their investments by giving unprofitable cash back to them. All in all, Apple's cash is now worth more - and that's why its stock gained value, too.
2. When initiating a dividend reduces shareholder value
"There will come a time - who knows how soon," Buffett said, "when we do not think we can lay out $15 billion to $20 billion a year and get something that's immediately worth more than that for our shareholders. But when that happens, the stock will likely trade down, since it's an admission growth has stalled," Buffett said.
Now this is a case where I feel many readers might disagree with Buffett. But, as he has explained, math is clearly on his side. As long as Berkshire can transform every $1 retained into more than $1 of market value, money given back to shareholders would reduce their overall returns. In most cases, a dividend would transform each $1 paid out into far less than $1 of market value simply because of income taxes.
Hence, while Apple's cash was worth more when given back to its shareholders (as the company is unlikely to find worthwhile investments for all of its cash), Berkshire's cash is worth more, because it is invested by Buffett and his investment officers. (Few people would doubt their talent in this field).
A few years ago, DirecTV (NASDAQ:DTV) was a company with slowing growth in the US, likely strong growth in Latin America, very reliable cash flows, quickly increasing intrinsic value, but slowly growing net income. And it was underleveraged. Management decided to take on additional debt in order to reduce aggressively shares outstanding. That's what they have done until today. From 2006 until today, shares outstanding have more than halved. Of course, some shareholders might have preferred dividends. But would it have been to their benefit? Here is a quick calculation:
Until September, 2013 DTV had spent $28.9 billion to buy back 59% of its float, reducing shares outstanding to 530 million from 1,282 million. If DTV had paid dividends instead, dividing the total amount spent of $28.9 billion into equal parts to pay out in each of the 8 years, shareholders would have received $3.61 billion per year or $2.82 per share and year, or a total of $22.56 over the whole period. In 2006, shares traded at an average price of about $19.50. If shares outstanding were still 1,282 million, at today's total market capitalization, the stock would trade at $30.5, bringing the total return to $33.56. But, thanks to the repurchases, DTV now trades at $77, meaning that shareholders who entered in 2006 enjoy a much higher capital gain of $57.5. (This calculation does not factor in that shareholders in the meanwhile would have had additional returns on the dividends received. But it would have required a more than doubling of the money received over time in order to beat the actual return of the stock obtained through the buyback strategy. On the other hand, the dividend itself would be totally unsustainable, because the company does not generate sufficient free cash flow to cover it, and this fact would likely weigh on the stock.)
The point here is that DirecTV's management felt sure about the strongly increasing intrinsic value of its business, which at that time was not at all reflected in the share price, and decided to enhance per share value increases by repurchasing shares, instead of giving money to shareholders. The amount of shares DirecTV could purchase on the open market had far more intrinsic value than the dollars needed to purchase them, therefore it would have reduced shareholder value if they had given those dollars to shareholders.
3. When cutting a dividend reduces shareholder value
This is the opposite of the first case. Admiral is a very cash generative British car insurer that has no debt and basically keeps all its cash in bank accounts or in money market funds. Let's imagine that Admiral plc (OTCPK:AMIGF) decides to cut its dividend to zero. Of course, its stock would fall like a rock - but this would not be the main problem. The problem would be that Admiral would probably not know what to do with the money retained, as fortunately its business model does not require a lot of capital expenditures. That's why Admiral has always paid out almost all of its earnings as dividends. If it suddenly started to retain all earnings (without providing a credible reason for the move), the stock market would be correct in attributing to the business less value than before. The money retained would have less intrinsic value than the potential dividends, as shareholders would likely be able to obtain higher returns compared to Admiral's bank deposits and money market funds.
When pundits criticize that Warren Buffett likes to receive dividends, but doesn't like to pay one, they lose sight of Buffett's focus on intrinsic value. Of course he likes Coca-Cola's (NYSE:KO) dividend - as the company, by keeping it on a bank account, would transform each $1 retained into less value compared to the value Buffett could generate with the dividend cashed in. This is also the reason for Buffett's preference for acquiring entire businesses; in these cases, he can be sure that every dollar not necessary for growth and maintenance will immediately be available for more profitable investments. But if Coca-Cola had the possibility to invest all earnings retained at high rates of return, Buffett would be very happy with a 100% dividend cut. And this leads us to the most controversial case.
4. When cutting a dividend adds shareholder value
I have recently bought some shares of Boardwalk Pipeline Partners (NYSE:BWP), a limited partnership company that owns and operates three interstate natural gas pipeline systems including integrated storage facilities. I bought the stock after it had fallen by about 60%, a panic reaction to the drastic cut to its distributions Boardwalk had announced on February, 10. While I understand that many income funds have no choice but to sell the stock, and many income investors are deeply disappointed, I believe that the move actually added value.
Please note that I'm talking about value, not about price. Before the dividend cut, in my opinion, BWP traded far too high compared to its intrinsic value. Nobody could figure out how the company would manage to grow distributions with shrinking earnings and an enormous debt load, yet the stock traded at 13 times its distributable cash flow, which was certain to contract in the near future.
However, the situation is now exactly the opposite: By cutting its distributions, Boardwalk has effectively found a solution to its problem. It will have about $300 million per year to invest for growth and/or to reduce its debt. If it hadn't cut its distributions now, earnings (and distributions) would have gone down anyway, while debt would have remained stable or even slightly growing. After a few years on that track, Boardwalk could have been bankrupt. Therefore I believe that cutting its distributions has actually increased intrinsic value.
The company now trades at less than 8 times its forecast distributable cash flow, which will probably remain about stable for the next few years, while debt should be no threat anymore. Patient investors are awarded with a 3.2% yield and will likely see increasing earnings and distributions at the latest 5 years from now.
When thinking about a potential investment, investors should focus only on its intrinsic value to a 100% owner. Hence, when a company changes its dividend policy, the question must be: "How does this change the intrinsic value of the underlying business?" In some cases, the answers may seem counterintuitive (as for example in the case of Boardwalk), but over the long run intrinsic value will be the most important factor determining the price of a business.
On the other hand, focusing on dividends alone is a dangerous game, as Boardwalk has clearly shown. I want to point out that this statement is true not only before, but even after the cut. Before the cut, investors focusing on dividends alone had lost sight of the underlying problems - while afterwards these same investors are losing sight of the cut's benefits. Dividend growth investors - who often are retirees or close to retirement and depend on their dividend income - too often base their investment choices exclusively on past dividend growth trajectories, taking for granted their future continuation. By analyzing business fundamentals and focusing on intrinsic value, however, they could avoid heavy losses of capital and current income. Moreover, they may find out that there are even non-dividend paying businesses that could fit very well into a diversified retirement portfolio: some, because they strongly increase shareholder value by retaining their earnings, and some that are very likely to initiate dividends in the future.