There has been a war brewing of late between those who invest in companies that payout a portion of earnings to the shareholder in the form of dividends, and those who feel dividends are neutral to being downright harmful to investors (see Are Dividend Stocks a Substitute for Bonds as one example). This article is not meant to be a re-hash of points made on either side, but to offer a couple of personal insights for you to mull over.
When a Company Has Too Much Cash
The logic goes that when a company runs low on high-return opportunities, it should either return a portion of earnings to shareholders in the form of a dividend, or institute a share repurchase program. Or it could just sit on cash to improve certain valuation metrics.
- Those that prefer dividends point to the superior historical performance of such stocks – particularly in market downturns (one of the many studies is Dividend Policy and Market Movements). They feel that the ability to pay a dividend signals the quality of a company and indicates how inside management feels about future earnings stability.
- Those that dislike dividends may claim that it is a bad use of cash. The dividend is taxed as income yet the dividend does not generate wealth-- it merely transfers equity from one pot to the next. The removal of equity from the company account limits the ability for growth, should an opportunity arise that requires cash. Some have a preference for share buybacks which will give share prices a momentum-like boost and will increase EPS. This will help stabilize valuation ratios at higher share prices, although it will not provide a long-term earnings growth effect once buyback is complete.
The counter-argument to share buybacks is that while good in theory, much depends on motive and execution. Some companies institute share buybacks to run up prices right before they sell their executive stock options, or to fund employee company options (see article) which does not create wealth, nor a sustainable price or true EPS increase, for the average shareholder. This makes me think of Cisco (CSCO) in former years. Timing is important too, as we saw Netflix (NFLX) repurchase shares between $200 and $300 and then turn around and dilute the share pool by offering shares at $70 apiece.
There is also the case being made for companies like Apple (AAPL) which use cash in creative ways such as subsidizing construction costs of factories for exclusive rights for a period of time and a discounted rate going forward. This article is not in any way dealing with management that has other creative strategies to create shareholder wealth, or which have many lucrative options for cash.
Round and round we go with this battle and where it stops, no one knows. Let’s leave this circular argument for a minute and consider two other possibilities of why dividends make sense for some investors.
- This article will deal with how dividends might allow you to remove book value at a bargain.
- Part two will talk about dividend stocks creating an anchor point in the minds of investors.
When One Dollar is Not One Dollar
When one dollar per share is paid out in dividends, how much does the share price fall on the ex-dividend date? One dollar. The company is transferring equity out of the company at a 1:1 ratio and you pay tax as it goes from capital gains to income. One dollar is one dollar – or is it?
Those that prefer a company keep the cash say that this equity is worth more than face value. Cash represents opportunity for future growth. One dollar kept by the company with a return on equity of 25% could be worth $1.25 this year, and left to compound for 10 years it is worth $9.31(assuming suitable investment opportunities continue to exist). What a waste it is to give the dollar to the shareholder who will pay tax and have inflation erode what is left. If this cash is worth so much to the company – why is the share price only discounted by the face value of the cash dividend? Well, anything less would create an arbitrage opportunity. While book value drops by one dollar per share, share price is not a simple one-to-one function of book value (or any other static ratio for that matter). Let me illustrate:
- Company XYZ trades at $10 per share. P/E is 10, meaning they earn $1 per share. Book value is $5 per share and half of the book value is cash. If the company sits on the cash and does nothing with it, what impetus is there for share price to grow? Perhaps you feel the share price will rise at a stable price to book value. Assume book value goes up by the total $1 per share earnings every year. Well then in 10 years time, what is a fair value for shares assuming a constant $1 per share earnings every year? If book value is $15 per share a decade later, should prices be at $30 using a former P/B ratio of 2? Does a P/E of 30 seem reasonable with 0% earnings growth?
- Company XYZ decides to pay out a one-time special dividend of $2.50 and institute a dividend policy using a 90% payout ratio. Share prices immediately fall to $7.50 to reflect the removal of equity. The cash pile they were sitting on was not being actively used and now shareholders have it. XYZ still earns $1 per share. The P/E ratio is down to 7.5 but the price to book ratio went up from 2 to 3. Will share prices stay this low? Consider that 90% of the earnings are being paid in the form of a dividend. This gives us a whopping 12% dividend yield, which many investors will jump on provided the company is stable. Even if share prices do not go up, you have a 12% return in a deep value company.
Of course, there are a hundred variations of how this could play out and each and every nuance would need to be considered.
But some principles can be reasoned on:
- Share prices drop equal to the dividend.
- This drop negatively affects the price to book ratio, but improves other valuation ratios such as ROE and P/E provided the dividend isn't killing high-growth investment opportunities.
- Investors might be more prone to act on the improvement of these certain ratios.
- This not only happens when a company announces a new dividend policy but on a small scale every single time a dividend is paid.
- Dividend income comes from earnings. It lowers share prices by the amount paid out. However, the earnings paid out does not necessarily impair the next earnings (it may lower future growth, but not necessarily make the company lose earnings beyond what they have now). Thus, lower share prices but stable earnings creates a earnings-based value inefficiency.
So while some call dividend investors zealots and maniacs, it may simply be that they understand how dividends can lower price to earnings ratios by lowering prices and subsequent excess gain, much like share buybacks increases EPS which leads to share price gain to maintain P/E ratios. Both practices remove one form of equity from the company and put it back into the shareholders hands in different ways. The difference is that buybacks allow management more opportunity to mismanage funds with ulterior motives and poor timing - which will harm value in the long run.
Your comments on both sides of the fence are welcome – just keep it respectful please and acknowledge differences of viewpoint.