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Tuesday, May 16, 2017

Dividends Are Not As Good As They Seem At First Sight, A Fast Way To Destroy Shareholder Value

When a company announces increased buybacks or hikes its dividend, the market usually reacts very positively. However, there are some people that aren’t so enthusiastic about dividends and especially buybacks as they see the former as a poor allocation of the company’s cash and the later as a fast way to destroy shareholder value. In this article, we’ll analyze why dividends aren’t as good as they seem at first sight.
Warren Buffett, the chairman of Berkshire Hathaway (NYSE: BRK.A, BRK.B), is famous for not paying a dividend since 1967 and joking that he “must have been in the bathroom” when the decision was made to pay out a dividend in 1967. However, those $0.10 paid out as a dividend in 1967 are a wonderful example of why Buffett is against dividends. Would he have kept that cash in Berkshire, thus compounding them with the 19% average increase in book value, today’s value would be around $600. If someone held a thousand shares of BRK in 1967, got $10 in dividends and went out for dinner, that dinner would be worth about $600,000 today. That’s as clear a message as any to question every dividend you receive, which is what we’ll do next.
Pros of a Dividend
A dividend generates income for shareholders, income that is highly appreciated especially by those who are retired. A dividend might also indicate that the business is doing well and that there is extra cash for the shareholders.
Cons of a Dividend
If a company pays out a dividend, that cash can’t be deployed toward the development of its current business, increasing efficiency, expanding the market, improving products, or widening the moat and separating the company from the competition. A dividend doesn’t allow for cash to compound internally.
On top of limiting growth, paying out a dividend includes additional taxation as the dividend is usually taxed on top of the corporate income tax.
Additionally, many companies have a fixed payout rate. However, a fixed payout rate might be good in some years but terrible in other years when there are excellent investment opportunities.
What I find peculiar is that there is an increasing number of companies that take on debt in order to pay dividends, thus focusing on improving short term perception through long term value destruction.
In aggregate, a dividend is highly likely to lower total returns, but it gives instantaneous pleasure which is a treat most humans can’t resist.
In his 2012 letter to shareholders, Buffett described why investors are better off without dividends. Assume you own a business that has $2 million in book value, and someone (the market) is willing to pay you 125% of the book value for a 12% return on that book value.
You might look at 12% return as a high return, but the situation described above is exactly what is happening with the S&P 500 at the moment. The book value of the S&P 500 is 769 points and the earnings are 95 points, this gives a 12.3% return on equity for the S&P 500. The market is willing to pay 312% of book value for that return, thus Buffett’s 125% is an extremely conservative assumption.
Back to the example, there are two options. In option A, the business pays a dividend, while in option B, the business reinvests all the earnings and the owner sells a percentage of his ownership to match the dividend income.
Let’s assume the dividend paying business has a 33% payout policy. This implies a dividend of $80,000 out of the $240,000 of earnings which increases the book value after the first year by $160,000. At the end of a 10 year period, the book value of the business would be $4,317,849 and the yearly dividend would be $159,920. The market value of the business would be $5,397,312.

Figure 1: Calculations for case a with a 33% dividend payout ratio. Source: Author’s calculations.
Option B is where the business doesn’t pay a dividend at all, but the owner sells part of his ownership to match the dividend payment. Since shares are sold at 125% of book value (at the moment, 312% of the S&P 500), the owner needs to sell almost 3% of his stocks in the first year for the same income yield.

Figure 2: Calculation for case without a dividend but with ownership sale to match the dividend income. Source: Author’s calculations.
In option A, the market value for the investor’s stake (100%) is $5,397,312, and in case B, the investor owns only 75% of the business but the market value is $5,870,829.51. After 10 years with the same income yield, the investor would be better off if the business didn’t pay dividends. This is because the business has less cash to compound and invest.
On top of the above, the dividend tax is calculated on the whole dividend while the capital gain tax would be calculated only on the gain made from day one to the sale date. For example, in the first year, the dividend tax would be calculated on $80,000 while the capital gain tax would be calculated on only $8,571, as that is the gain made in year 1 on the investment.
The above shows just how illogical it is to pay a dividend and is an additional proof of how markets and management are irrational. Since 1965, Buffet has managed to increase the book value of Berkshire by 19% per year which has resulted in a 20% per year return. In the same period, the S&P 500 returned 9.7% per year including dividends.
As some food for thought, imagine how Microsoft (NASDAQ: MSFT) would look now if they hadn’t started paying out dividends in 2003 but instead had used their knowledge to develop or invest money in early financing rounds of new businesses like social networks, digital televisions, video platforms, or something similar.
For the record, MSFT’s stock didn’t appreciate at all from 2003 to 2013.

Figure 3: 10 years of dividends didn’t move the stock price. Source: Yahoo Finance.
What I don’t like about Apple (NASDAQ: AAPL) is the fact that they aren’t using their cash for anything other than dividends and buybacks. It looks like the management is content and trying to keep the status quo instead of using the firepower they have to change the world. If still alive, Jobs likely wouldn’t approve of current management.
The problem is that if the manager pays out a dividend, the shareholder is happy and nobody is forcing the manager to do more or to look for better investment opportunities. Further, forcing the manager to look for new investments might lead them to invest in high risk projects that would ultimately destroy value.
There is almost no debate about dividends, 99% of investors like them. It’s left to the likes of Buffett to keep up the face of rationality. Somehow, I have the feeling his Berkshire will continue to outperform the S&P 500 for a long time.

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