In this post I am going to tackle dividends, and dividend yield. First I am going to focus on the capital allocation aspect of dividends, and then there will be a brief discussion about dividend yield.
Paying high dividends means that the company uses a lot of the cash it generates to pay dividends to the holders of common equity. Why I dislike this as an investment thesis might become clearer after we take a look at the five ways a company can allocate its capital. These five capital allocation decisions are:
- Reinvest in the operations
- Acquire businesses
- Repay debt
- Repurchase shares
- Pay dividends
A company with a large market up ahead, or a company in earlier stages will have no choice but to reinvest in the operations, such as developing new products or expanding geographically. An alternative to investing directly into the operations is acquiring another company. This is another topic, but there are both good and bad reasons for acquisitions. This is similar to reinvesting in the operations, since it requires that company thinks there is potential for greater profits if they scale up the business.
The company can also decide to lower the debt burden by repaying loans, or repurchasing bonds. This is equal to distributing cash to debt-holders. This alternative signals that the company thinks the level of debt is impairing the business, either because of bankruptcy risk, or because it hinders the business from taking action. This could also indicate that the business can’t find better investment opportunities than lowering the financial expenses. This is because a net cost reduction of 1$ is the same as a net gain of 1$.
The company can also buy back their own shares. This can either be done in a clever way, where the management believe their company is being undervalued by the market, or in less clever ways. It is quite common for companies to have predetermined buyback programmes, usually to offset the dilutionary effect of options or incentive programmes. There are also companies that use buyback as a part of their dividend programme, usually for tax purposes. Finally, there are buybacks where the company is buying back shares at a price which they determine is below fair value. It is this last option that can add value to the firm, since it is favourable for the company to buy their shares back from shareholders who are willing to sell, at a price that is below intrinsic value. This can also signal that the company is undervalued, given that the management has a history of good capital allocation. The others cases of share buybacks simply redistribute value from the company to the shareholders, and can possibly be destroying value for the company if it’s buying an overvalued asset.
Finally, the company can give the money to the shareholders. There are two downsides to this. First of all, it signals that the company cannot invest the funds at an attractive return within the business. The marginal return on capital within the business it less than the return the company assumes the shareholders can get on their own. Secondly, dividends also trigger double taxation, since the company has already paid corporate tax on the funds, and then the investor has to pay tax on the dividend received.
In other words, companies that pay high dividends in relation to their earnings, indicate that they have no good investment opportunities within the business. They cannot earn a higher return on their money than the investor can. A dividend is simply the company giving you money that you already own. If it is possible, it is better to reinvest it in the business, given that it is high quality, than to give it to the shareholders. In some cases you even see such inefficient behaviour as companies both issuing shares and paying dividends. In other words, taking money from shareholders AND paying out money to the shareholders. It is also not unheard of companies increasing their level of debt while paying a dividend.
Moving to dividend yield. To start, what information does the key ratio “dividend yield” carry? It is the cash dividend divided by the share price. Therefore, a higher dividend yield means that the dividend is larger in relation to the share price. This means that the price of the business is lower in relation to the dividend they pay. This makes it a measure of price, and not a measure of quality.
Buying companies solely because they have a high dividend yield is the same as buying it only because it looks cheap on a surface level. This disregards the quality of the company, and there are usually reasons why a company looks instantly cheap on a surface level. This approach is similar to picking stocks on the basis of a low price to earnings ratio. Low P/E stocks usually have a very good reason for trading at low multiples. Often along the lines of very low expected future earnings. This should lead to the conclusion that only looking at a stocks dividend yield is insufficient analysis of the business.
There are of however some merit to dividends. For example, there is nothing wrong with a business that has inherent lack of scalability or growth opportunities, but that still produces large amounts of cash. In such a case, paying the majority of cash flow as dividends is very wise.
The most important takeaways are the following:
- Dividends are not value adding in and of themselves, but they are not categorically bad. It is first and foremost one part of a deeper analysis of the managements capital allocation decisions. Bad allocation of capital can be devastating for a business, and it is one of the most important aspects to consider when determining the value of a business.
- Dividend Yield is a measure of PRICE, and nothing else. It is an inherently uninformative number by itself, and the analysis should start on the cash flow statement.
- The question to ask yourself should be “How much money is being paid out in relation to free cash flow, is it sustainable, and is there something more profitable they should put the money towards”.
To summarize this post, investing in a business that has an abnormally large focus on paying a dividend is equal to investing in a business that is not correctly evaluating all possible capital allocation decisions. In the long run this should lead to lower return on invested capital, and thus the overall return of the business. Now as I previously stated, paying a dividend is sometimes the correct allocation of capital, but promising a monthly dividend, or an ever increasing dividend can lead to poor decisions in the short term that weighs down the long term returns. The same issue also arises in the cases where companies blindly decide to follow one route of capital allocation without assessing the alternatives. Such as investing too heavily in a declining business, or pursuing acquisitions while disregarding the prospective returns on the target company.