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Dividend Policy, Strategy and Analysis_Value Vault

Dividend Policy, Strategy and Analysis_Value Vault

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Published by John Aldridge Chew

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Published by: John Aldridge Chew on Dec 12, 2011
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Dividend Policy and Analysis from Graham to Buffett and Beyond plus Case Studies
 
www.csinvesting.wordpressstudying/teaching/investing
Page 1
 Do you know the only thing that gives me pleasure? It is to see my dividends coming in.
 
 – 
 John D. Rockefeller, 1901
Dividends, share repurchases, maintenance and growth capex and growing retained earnings are allaspects of capital allocation.
Charlie Munger on paying cash out or keeping it in the business.
When we have capital around, we have three questions
..First,
Does it make more sense to pay it out tothe shareholders than to keep it within the company? The sub-question on that is,
If we pay it out, is itbetter off to do it via repurchases or via dividend?
 The test for whether we pay it out in dividends is,
Can we create more than a dollar of value within thecompany with that dollar by retaining it rather than paying it out?
 And you never
know
the answer to that. But so far, the answer, as judged by our results, (BerkshireHathaway-BRK.A) is,
Yes, we can
. And we think that prospectively we can. But that is a hope on ourpart. It is justified to some extent by past history, but it is not a certainty.Once we have crossed
that 
threshold, then we ask ourselves,
Should we repurchase stock?
Well,obviously, if you can buy your stock at a significant discount from conservatively calculated intrinsicvalue and you can buy a reasonable quantity,
that 
’ 
s
a sensible use for capitalBeyond that, the question becomes,
If you have the capital and you think that you can create more than adollar, how do you create the most value with the least risk?
And that get to
business
risk 
.I candetermine it by looking at the business, the competitive environment in which it operates and so on.So once we cross the threshold of deciding that we can deploy capital so as to create more than a dollar of present value for every dollar retained, then it is just a question of doing the most intelligent thing you canfind. And the cost of every deal that we do is measured by the
second 
best deal that
s around at a giventime
 — 
including doing more of some of the things we are already in. (
Seeking Wisdom from Darwin to Munger 
by Peter Bevelin)--At www.csinvesting.wordpress 
we continue our study of capital allocation from an insider’s perspective.
. 
Our goal is to understand dividends from different perspectives and their context. An ideal investmentwhere capital can continually be compounded at high rates would not pay us a dividend because such anact would create less value for shareholders.
We now go more in-depth on the dividend question.
 
Dividend Policy and Analysis from Graham to Buffett and Beyond plus Case Studies
 
www.csinvesting.wordpressstudying/teaching/investing
Page 2
Category:
Management
 Sub-Category: Capital AllocationSubject:
Paying out dividends or retaining the money
 MM = Modigliani-Miller thesis.
“The most important objective of an investor is a rewarding total return.”
Geraldine Weiss
1
 
INTRODUCTION
The central issue can be stated quite simply.
It is whether the surplus, freely available earnings of thecompany will earn more for the shareholders if left in the business or if distributed to them, eitheras cash dividends or by share repurchases.
All the freely available earnings
 — 
what we call availablecash flow
 — 
are potentially available for distribution to shareholders rather than being
routinely
reinvestedto expand old businesses or diversify into new.
Economists tell us that a company’s dividend policy will have
no effect on its stock price. How can thatbe? If it is a mature company, shareholders rightly expect it to pay out a high percentage of its earningsand not to go off on a (probably) wasteful diversification spree. Keeping the money, or paying it out toshareholders, should be a major concern for management. The
 dividend irrelevance theory
assumes thatthe investment policy of the company is known and fixed, as if the fact that excess earnings are sloshing
around in the company’s treasury might not tempt a CEO to buy a jet or expand a corporate empire. No
matter how talented of foolish the CEO may be, we are asked to believe, that (taxes aside) a dollar leftinside the company with little or no control over how it is utilized, is as valuable to investors as oneoutside.Scholars have been straining to make of finance a hard science that can be reduced to algebraiccompositions and tests by quantifiable data. They ignore the stuff of history and social insights that do notfit the algebra. The price of this mathematical elegance obscures hard, practical questions that executivesshould be asking, even one as basic as whether to pay a dividend or keep the money for internal growth.On average (as of 1990), American industry has been paying out as dividends a little over 40% of earnings and many companies seem to believe that if they follow the crowd or pay out just a bit more than
the crowd, they have given shareholders “their due”.
2
Depending on the investment opportunitiesavailable to management, shareholders have a moral claim
 — 
there is no legal one
 — 
to something morethan that. It is a more exacting and appropriate way to run the business.
 
There is no benefit in owning a good business if the profits are neither distributed to theshareholders nor reinvested wisely.
There are not very many, in the sense of being able to earn returnson capital that are consistently above average.
What is striking is how difficult it has been for the
 
managers to reinvest the earnings well.
Undaunted by past failures, many of them insist on buying
1
 
Geraldine Weiss and Gregory Weiss
 , The Dividend Connection
, Chicago, Dearborn Financial Publishing, 1995, p. 2. The average yearlydividend yield of the 30 DJIA stocks was 4.4 percent that compounded stock returns look respectable again.
2
See Appendix for a recent dataset on dividend yields.
 
 
Dividend Policy and Analysis from Graham to Buffett and Beyond plus Case Studies
 
www.csinvesting.wordpressstudying/teaching/investing
Page 3
 
businesses that are inferior to what they already own and know, buying good ones at excessive prices, orbuying ones outside the area of their experience and expertise--far better to have paid dividends
3
.How much should companies pay out as dividends, as against what they keep for investment
 — 
has been apuzzle. Just how much do dividends really matter to shareholders?
 Ben Graham
liked to think about thethe
oretical possibility of a “frozen corporation,” one that by its charter was forbidden to pay dividends or 
even merge or liquidate. If they could never, ever see any cash or other distribution from the company,why would ordinary investors want to own the shares? At what price would the shares trade? Fortunatelycompanies that can pay dividends eventually do.According to
 MM 
, a company’s dividend policy is irrelevant even for shareholders who want a present
cash return. If the company does not pay dividends, investors are free to do what the shareholders of any
“frozen corporation” can do: sell some shares periodically in the open market. Depending on the taxstatus of the shareholder, these “homemade”
dividends may even be the preferred course.Since the famous MM thesis states that dividend policy is irrelevant, it tends to reinforce the preference of 
corporate managers to keep dividends as low as possible. The MM theory puts a patina on management’s
self serving tendencies to hold on to the money, expand their business, buy and try a new one, or just feel
more secure with more cash in the drawer. If dividends are irrelevant for shareholders, they won’t pay
more for dividend-paying stocks. Thus, dividends are irrelevant for corporate managers, too. Howconvenient.Economists and finance people are thinking almost entirely about the impact of dividend policies on thecurrent market value of the company, not the impact on the business itself. The professors do not addressthe critical issue of 
how a company should reinvest its cash flow
. The scholars assume that they know
how
the money will be invested, thus the only question left is the purely financial one of where the moneycomes from:1.
 
Retained earnings or2.
 
The market place if a dividend is paid.And, according to efficient market hypothesis (
EMH
) theorists, because the source of the money--a
company’s choice between debt and equity— 
is said to be irrelevant in market terms
(CAPM or capitalasset pricing model)
, dividend policy is irrelevant too. In other words, the very issue that a businessperson sees as paramount
 — 
the choice between putting money back in the business or paying it toshareholders
 — 
they break up into two ostensibly unrelated ones. Absurd.
3
 
Coca-Cola once diversified (read
 Di-worsified 
) into shrimp farming. Yes, shrimp farming. The venture failed because what connection is there
in the customers’ mind between drinking Coke and buying shrimp— 
a branded good and an agricultural commodity? Former Coca-Cola Chief Marketing Officer Sergio Zyman explains why renovation of an existing brand is a better way to go. Associations can learn from the innovationerrors of the corporate world. Coke, for instance, once got into the shrimp farming business. No, I'm not making this up. Coca-Cola had fantasticcore competencies in purchasing, distribution, sales, logistics, and global operational capabilities. Where it all fell apart was that Coke neverthought about why customers would buy shrimp from them in the first place. Shrimp farming was not the company's core essence. Consumerssimply made no connection between shrimp and Coke. What are you doing that makes members raise an eye or give a quizzical look when (or if)they learn about your association's involvement?
 

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