Dividends Make Companies Worth Less, But Not Necessarily Their Investors

by: Tim McAleenan Jr.

I have watched from afar the recent Seeking Alpha debate over whether dividends are an inherent source of value, and whether the payment of dividends negatively affects the value of the dividend-paying company. While I realize that I'm late to the party (and worse, I didn't even bring beer), I would like to add what I hope are some original insights that may influence your consideration of dividend-growth companies.

First of all, I would like to answer the question: Does paying a dividend make a company worth more, equal, or less? While it's impossible to answer this question in the sense that the market can choose to value a company however it wants, I will argue that the payment of a dividend should make a company worth less.

Let's say that I have $170 billion laying around the house (walking around money, as I like to call it). Right now, that also happens to be about the total market value of the entire Coca-Cola (NYSE:KO) enterprise. The company currently pays all of its shareholders about $1.1 billion in dividends every three months. Coca-Cola currently has $18 billion in cash assets (for the purpose of this example, we'll ignore the firm's debt). After haggling with Coca-Cola's executives on the purchase price, we agree upon the figure of $170 billion. Then they ask me: Do you want to take over before or after the December 17th, 2012 dividend payment? Let's see here: for $170 billion, I can choose to purchase Coca-Cola with $18 billion in the bank or Coca-Cola with $16.9 billion in the bank. Which one do you think I'm going to think is worth more? Of course the act of relinquishing cash from company coffers to the pockets of individual investors makes the company worth less.

But stopping the debate there gives a false impression. It might hint at the fact that "dividends are bad." But to complete the discussion, we must look not to the effect that the dividend has on the net worth of the company, but on the investor. If I own 1,000 shares of General Electric (NYSE:GE), the company may be worth less after it pays out the $170 quarterly dividend, but that does not mean the investor is worth less because he is now in possession of two things: (1) those 1,000 shares of General Electric that just paid a dividend, plus (2) $170 that he can do with as he pleases. And, of course, one of the automatic options is to increase your ownership of the dividend-paying company without any further effort on your part, thus giving you a larger claim to the company's future earnings and dividends. If you own your GE shares in a tax-optimal manner, and assuming you reinvest at $21 per share, you now own 1,008 shares of GE. For those of you investors that sit back after pressing the "reinvest dividends box" on your brokerage accounts, you automatically go from having a claim on $1,347 in earnings and $680 in annual dividends to having a claim on $1,357 in earnings and $685 in annual dividends (and this is offset by the fact that the company experienced a temporarily removal of some of its cash on hand). Although the company may temporarily be worth less, you have made the trade-off of receiving a larger ownership share of GE with greater rights to future dividends and earnings.

From a total return perspective, it is very difficult to make a blanket statement about whether a dividend is good or bad. We have no idea what a company will do with retained earnings-Sam Walton did things with retained profits at Wal-Mart (NYSE:WMT) that the executives at Sears (NASDAQ:SHLD) could only dream of. If Coca-Cola stopped paying dividends for a year or two, could it enrich shareholders further by taking over Dr. Pepper (NYSE:DPS), thus earning a fantastic return on capital that would be more beneficial than the dividends paid out? If done right, probably. On the other hand, how many Bank of America (NYSE:BAC) investors wish that the cash used to buy Countrywide Mortgage could have been paid out to shareholders as a dividend instead?

There's such a wide range of outcomes for what a company can do with retained earnings that it's impossible to play the "what if we didn't pay a dividend?" game, but I would caution that it's wrong to assume that more retained earnings (and thus lower dividends) usually translates into high growth.

Dividends, in a way, can force a company to only focus on its best ideas. Procter & Gamble has generated about $8 billion in earnings over the past twelve months. If left to their own devices, the executives could easily come up with $8 billion worth of ideas to spend the money. Ahh, but the company is committed to paying out $6 billion to shareholders. That's a product of the commitment to dividend-growth that has been going on at headquarters since 1957. What is the consequence of that? Without adjusting for debt repayments and other liabilities, the company is forced to focus on its $2 billion worth of "best ideas" as opposed to $8 billion worth of ideas, and if the right projects are chosen, the company will earn a higher return on equity with the $2 billion worth than the $8 billion worth. To put it in textbook economic terms: you should not assume that the company's "last" dollar of profit will be deployed as effectively as its "first" dollar of profit. By having a commitment to dividends, investors can force a company to only work on "first" dollar ideas, as opposed to "last" dollar ideas.

There are too many variables and moving parts to definitely say that dividends (in and of themselves) make an investor richer or poorer. Factors such as your tax bracket (and as a subset of that, how you allocate your investments across tax-deferred and taxable accounts) and the craftsmanship of the management teams running your stock holdings ensure that the benefit of dividend vs. no dividend will vary on a case by case basis. But there are two general rules of thumb that investors could do well to keep in mind: just because paying a dividend makes a company worth less, it does not mean that the investor is worth less. And just because a company is able to deploy "the first dollar" of profits well, don't assume that removing a dividend will ensure that a company will be able to deploy its "last dollar" of profits just as well.

Disclosure: I am long GE, DPS, BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here