Author: Ben Tewey

Published: 3/14/21

What is a Dividend?

Dividends are a distribution of some of a company’s earnings to its shareholders that are generally paid out in cash or additional stock. 

When Should Value Be Returned to Shareholders?

The only reason for owning a business- exactly what you do when you buy a stock- is for it to return more money than what you put in. Therefore, the natural question becomes: when should a company pay a dividend or in other words return value to its shareholders? In short, the company should pay a dividend when a dollar reinvested into the business is worth less, or invested at lower rates of return, than a dollar returned to shareholders could be. Now that may seem difficult to measure, so let us heed Charlie Munger’s advice, “Invert, always invert.” 

In that case, the question we should be asking ourselves is: when should a company not pay a dividend? Again, the answer is simple: when a dollar retained in the business is worth more because it can be reinvested at higher rates of return than if it were returned to shareholders. If the money that would be returned to shareholders can be more effectively deployed in the business it would deliver more value to shareholders rather than simply returning it to them in the form of a dividend. By way of example, we know the market returns an average of 7-10% per year, therefore if a business can reinvest capital, measured through return on invested capital, at a rate higher than 7-10% say, 20%, than that business should not pay dividend because a dollar retained is worth more in the business than it would be taken out of the business. If a company is going to retain every dollar it earns, it better be turned into more than a dollar in market value. The only reason for a company to keep your money is if it would be worth more keeping it in the business than giving it back– that is the standard you should hold non-dividend paying companies you are invested in to. It is important to highlight that the very best kinds of businesses are ones that can earn high returns on capital employed and can take very large sums of money, in essence these businesses become compounding machines and in most cases earnings should be retained by these lollapaloozas.

So What if ROIC is Lower than Market Average?

Of course, the business should pay a dividend and return part of the earnings back to the shareholders in cash so that they may find better opportunities to deploy their capital for higher returns. This is the policy followed in a private partnership, there is no reason for it to be different in a publicly traded company unless, of course, management is not owner oriented or their compensation rewards such value-destroying behavior.

Stock Repurchases as Means of Value Return

A second form of value return for a company exists known as share repurchases or buybacks. Apple recently announced a bump in its buyback program so it is relevant to mention.  A company should only repurchase its shares when the security is trading below its intrinsic value and doing so will leave the remaining shareholders better off the moment after the repurchase than the moment before because their interest in the business was just increased at a discount. This is only the case when the stock of a company is trading below its intrinsic value. This will increase the shareholders’ interest in the business without them shelling out any additional cash to achieve this. To help illustrate three people start a brewery together. They all chip in $100,000 and they get along just fine, but after a year, person A sees a vacation in a magazine that they really want to go on, and in order to finance this they take out a portion of their earnings of the coffee shop made that year. On the other hand, Person B and C want to leave their portion of the earrings in. Instead of paying a dividend out, the logical thing to do is to buy out part of Person A’s share. In this case the interest, share of earnings, of the other two go up because of the money they left in and Person A has a slightly lower interest.

In either case, dividends or share buybacks, you are returning value to the shareholders. In dividends earnings are shipped out to all the holders and in repurchases those who want cash get some, but their interest doesn’t increase and those who want their interest to increase don’t get cash. 

It is important to emphasize that repurchases should only be done at levels below intrinsic value and should not be used to inflate the sock price in order to drive management compensation.

Disclosure

I am not a financial advisor. These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments. Please consult your financial or tax professional prior to making an investment.

Bibliography

Rationale Behind Share Repurchases

Warren Buffett on Share Buybacks at 2019 AGM

Buffett Discusses Share Buybacks

Buffett On CNBC Discussing Berkshire Repurchases