RE: Silly Rabbit, Dividends Do Matter...

by: Brian Nelson


I love variant perspectives, but at times, there's just too much (mis)information out there, where it has become harmful to the individual investor.

Let's talk about why dividends do and don't matter. We'll also cover the many measures of cash flow to help bridge the gap between schools of thought.

The main takeaway of this article is that the answer to whether dividends matter depends entirely on one's perspective.

From: Brian Nelson, CFA
Date: July 21, 2014 12:47 pm
To: Readers of "Silly Rabbit, Dividends Do Matter…" and "Dividends Don't Matter..."

There is truth to both -- that dividends do matter and that dividends don't matter.

For valuation experts, and in the context of a free cash flow to the firm (FCFF) model, the only thing that matters is what a firm generates in enterprise free cash flow (FCFF), not how that enterprise free cash flow leaves the business, per se (1). I'll list the many different definitions of cash flow at the bottom of this memo.

When calculating intrinsic value, dividends and/or distributions do not matter to valuation (other than when a dividend and/or distribution is paid, the intrinsic value of a firm is reduced by the amount of the dividend and/or distribution). Please read more about how dividends interact with valuation here.

Price is different than value, however, and investors can drive the price of a stock, as a result of its dividend, far greater than its intrinsic value. Some then may conclude that the dividend does matter because, in the case when dividend growth investing is in vogue, the dividend can push a firm's stock price far beyond the fundamentals that tie it down (as dividend growth investors pile into the equity).

The e-book below explains how only through the buying or selling of an equity does a company's share price move. Value, on the other hand, is based on the future enterprise cash flows (FCFF) that are generated (not cash flows that are paid) by the entity. However, the payment of these cash flows in the form of dividends could still cause income investors to bid the firm's stock price higher.

Two places for additional information thus far:

1) Valuentum's academically-sound and professional-tested FCFF model.

2) Valuentum's e-book on the "13 Most Important Steps to Understand the Stock Market"

Absent the income stream that serves a vital purpose in retirement, the answer to if dividends matter or if they don't depends on your perspective. If you are a value investor, then dividends paid don't matter to the valuation (remember they can matter to the price). But if you are a dividend growth investor, dividends certainly do matter--this is your strategy. And if investors are overpaying for yield, the prices of these equities will go higher, and in this light, for investors focused on capturing this upside, dividends matter.

The view that paying out all excess cash flow as dividends and/or distributions enforces capital market discipline may be true (in the cases of MLPs and REITs), but doing so also significantly increases capital market risk/dependence. Distribution and/or dividend cuts from Boardwalk Pipeline (NYSE:BWP) to Exelon (NYSE:EXC) to First Energy (NYSE:FE) were all tied to the fact that these entities did not have a large net cash position on their balance sheets. MLPs and REITs are unable to build large cash balances to handle exogenous shocks. Their dividend safety, as a result of their dependence on the capital markets, is lower than those entities with gobs of cash flow -- think Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Qualcomm (NASDAQ:QCOM), etc.

For income investors, they want both growth and safety -- certain business structures such as MLPs and REITs are less safe than general corporates because they require the entity to be significantly dependent on access to the capital markets, which is never guaranteed (think recent credit crunch and the Global Financial Crisis).

Though there was a reference to Morningstar's dividend book in the article, it should be known that more than a handful of the firms included in the firm's dividend portfolios (shown in the book) slashed their dividends -- not only in the banking sector but also within energy:

"Associated Banc-Corp (NASDAQ:ASBC) cut its dividend January 2010, BB&T (NYSE:BBT) cut its dividend in May 2009, US Bancorp (NYSE:USB) cut its dividend March 2009, Wells Fargo (NYSE:WFC) cut its dividend in March 2009, First Horizon (NYSE:FHN) cut its dividend in January 2008, and Bank of America (NYSE:BAC) cut its dividend October 2008. Interestingly, even energy firm Crosstex (XTXI) cut its distribution October 2008."

The Valuentum Dividend Growth portfolio has yet to have a dividend cut, and we credit this to the framework behind the Dividend Cushion methodology. Our Dividend Growth portfolio houses our favorite dividend growth ideas; it can be accessed here.

All-in-all, whether dividends matter or not simply depends on your perspective.

As promised, here are just a few cash-flow related definitions:

Free cash flow to the firm (FCFF) or enterprise cash flow: the estimated cash flows that accrue to all stakeholders (equity + debt + preferred). The measure equals earnings before interest (EBI) less net new investment NNI). Total debt and total preferred is subtracted from the present value of future enterprise cash flows (FCFF) to arrive at total equity value. Free cash flow to the firm is a measure calculated for equity valuation purposes. Free cash flow to the firm includes cash generated organically for future investment purposes, cash generated that is stored on the balance sheet, cash paid for interest and on preferred dividends, and cash returned to shareholders in the form of dividends and share buybacks.

Cash flow from operations: This is an accounting item found on the cash flow statement. It is typically calculated by adding depreciation and amortization to net income and accounting for changes in working capital. Cash flow from operations is the source of cash earnings of the company. Total capital expenditures (maintenance + growth), found in the cash from investing section on the cash flow statement, are subtracted from cash flow from operations to arrive at traditional free cash flow--FCF.

Free cash flow : Cash flow from operations less total capital expenditures (maintenance + growth). This is a non-GAAP measure that is followed by most analysts and presented by most management teams within press releases corporate presentations. This is a great short-hand measure to assess free cash flow conversion, earnings quality, free cash flow yield, and a variety of other analytical considerations. For general corporates, dividends are paid with free cash flow (or from cash held on the balance sheet in periods where free-cash-flow shortfalls occur).

Distributable Cash Flow (DCF): This is found in MLP structures and is typically calculated as cash flow from operations less maintenance (sustaining) capital expenditures. MLPs typically use distributable cash flow in the numerator of the distribution coverage ratios they publish. Distributable cash flow is subject to a variety of estimates regarding sustaining capital expenditures and is not a complete measure of free cash flow as it does not consider the growth capital expenditures that are used to drive future expansion in cash flow from operations.

Discounted Cash Flows (DCF): Though sharing the same abbreviations as distributable cash flow (immediately above), the measures are completely different. Discounted cash flows represent the present value (discounted) enterprise free cash flows (FCFF) of an entity and are summed up to derive, in part, the total value of the equity of a firm. Discounted cash flows are not found anywhere else, except within the valuation context of a firm.

Thanks for reading.

Kind regards,

Brian Nelson, CFA
President, Equity Research
Valuentum Securities, Inc

(1) Learn how share buybacks impact valuation here.

Note: For valuation purposes, dividends and distributions are interchangeable (both are accounted for in the cash from financing section of the cash flow statement). For tax purposes on the individual level, there are significant differences between the two.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Several firms mentioned in this article are included in the newsletter portfolios.