The following chart shows the returns on average equity for two companies over a decade.
Returns on Average Equity
Each company begins in the same spot, yet one begins an inexorable decline while the other maintains enviable performance. High and sustainable returns on equity are desirable and are one indicator of a business with a competitive advantage, so most investors would prefer to invest in Company A.
Now what if I told you that this is the same company, but with two different dividend policies? In Scenario A the company paid out nearly all of its net income each year, while in Scenario B it retained this as cash earning 4% pre-tax. Would this affect your desire for Company A over Company B?
On the one hand, by retaining cash at a very low reinvestment rate Company B’s returns declined dramatically and deprived shareholders of the opportunity to put that cash to a greater use elsewhere. Furthermore, managements of companies that hoard cash like Company B tend to waste the capital on empire building acquisitions that ultimately destroy shareholder capital (though they do try to fool shareholders by pointing to how accretive the transaction will be. Remember that the transaction will be accretive anytime the target earns above the “hurdle” rate of what the cash hoard is generating, which in a low interest rate environment is close to nothing).
So Company A is the best investment, right? Not necessarily; that high payout ratio deprives the company of financial flexibility that might be desirable should an opportunity arise that buy a business in its industry (perhaps one that earns 40%+ returns like itself) or even to expand its own business. Furthermore, Company A’s shareholders may have grown accustomed to its high dividends which makes a dividend cut potentially disastrous for its share price, effectively shackling the company with an obligation that is difficult to unload. In order to avoid upsetting shareholders, many managements will do whatever it takes to avoid a volatile dividend policy, even if it means paying out more than free cash flow or net income in a year (dipping into already low cash balances). Is a bird in the hand worth two in the bush, if you’ve destroyed your bird-creating bush?
Let’s look at a more concrete example. Compare Microsoft (NASDAQ: MSFT) and Apple (NASDAQ: AAPL). MSFT has paid a regular dividend since 2004, while AAPL has never paid a dividend. Over the last six years, MSFT has averaged 40.5% returns on equity and paid out $25.6 billion. Over the same period, AAPL has averaged 26% returns on equity, paying out zero.
Going back to the chart above, MSFT is Company A and AAPL is Company B. Putting it this way, many investors immediately choose Company B despite declining returns (though, it is worth noting that AAPL’s returns are in fact increasing due to its neverending string of hits and despite its massive cash balance). AAPL has accumulated $81.6 billion of cash and securities, which is greater than its current shareholders equity of $76.6 billion. AAPL could easily report ROEs at the level of MSFT if it simply paid out a chunk of its cash hoard.
Also, to give MSFT its due, the company has managed its stunning returns and payout while accumulating $66 billion in cash and securities, which is also greater than its shareholders equity of $59.4 billion. Arguably, both companies could be paying out significantly more without compromising their financial flexibility and report even more impressive returns. Given MSFT’s recent purchase of Skype, it would probably be advisable to take away Ballmer’s piggybank, but I digress.
The point is that a company’s dividend policy has a big effect on its returns on equity over time. I would choose a Company B any day of the week over a Company A that has left itself in a precarious position with a too liberal payout policy, but I would choose a Company A with a reasonable dividend policy over a Company B run by management with an itchy trigger finger. In either case, investors must make the distinction between “poor” returns and returns that are artificially depressed by conservative cash management, and “great” returns that are inflated by too liberal payout policies.
Just in case you are interested, the “companies” shown in the first chart is Landauer, Inc (NYSE: LDR). How do you assess dividend payout policies?