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Interplays with capital gain must be understood to find sustainable yield.

Photo of Michael Kemp By Michael Kemp, author

In 1938 John Burr Williams published his classic book, The Theory of Investment Value, in which he said share value is determined by the discounted value of anticipated future dividends. If that is true, why do we often see high valuations placed on companies that pay low or no dividends?

If value is determined by dividends, why has Warren Buffett, of Berkshire Hathaway, delivered only one dividend to shareholders during his 46-year stewardship of the American company? And this in a period in which Berkshire's share price increased 6000-fold.

Alternatively, why has the share price of Telstra, one of Australia's best dividend-paying companies, fallen by 70 per cent over the past 12 years?

Clearly there should be more to the sophisticated stock-picker's skill than simply chasing dividend yield. Some of the unappreciated issues surrounding dividend policy and its impact on wealth creation will be discussed in this article.

Where returns come from

To resolve the dividend conundrum, let us start by considering the factors that contribute to total share returns. Most investors know they come from two sources, dividends and capital gains. But there are interplays between the two that need to be understood if we are to make better investment decisions.

Companies typically pay dividends as a partial distribution of company profits. Retained earnings are reflected in the Statement of Financial Position as an increase in shareholders' equity. Hence a lower payout ratio provides a larger pool of capital for management to invest, and if this new capital is put to good use then larger profits will be generated in the future, giving the potential for larger future dividends.

That sounds great in theory, but empirical studies have demonstrated that greater profit retention does not automatically lead to higher profits and dividends.

By way of example, Arnott & Asness (Financial Analyst's Journal 59:1, 2003) observed a positive relationship between higher payout ratios and higher subsequent 10-year real earnings. A later study by Zhou & Ruland (Financial Analyst's Journal 62, 2006) came to a similar conclusion.

For higher earnings growth to follow higher rates of payout would seem to be counterintuitive. What might be going on?

Theory v. reality

The reality is that dividend policy is more commonly an instrument of wealth distribution than an instrument of wealth creation. This subtlety escapes most investors. Also, because dividend policy has the potential to be influenced by a number of conflicting factors, the purist's claim that it should be undertaken to "maximise shareholder wealth" often gets pushed into the background. Consider the following:

  • Empire building
    Managements can at times be accused of empire building at the expense of the shareholders' best interests. Earnings are retained rather than distributed so that a war chest of capital is accumulated for the purpose of targeting potential acquisitions. Benjamin Graham, author of The Intelligent Investor, referred to this as "personal aggrandizement". But if acquisitions are made at excessive prices, the resultant low returns on capital will lead to destruction of shareholder wealth.
  • Dividend aversion
    Also influencing dividend policy is managements' aversion to reducing the dividend when profits are lower. Their fear is that a dividend reduction would send a negative signal to the market in relation to the company's recent performance and future prospects. Therefore, to keep the dividend steady there is a tendency to increase the payout ratio when profit is down. This typically happens at low points in the economic cycle. As the economy recovers, so too do company profits. Under this scenario, profit growth follows a period when there has been a high payout, not low.
  • Lack of investment options
    If management cannot invest retained earnings at a rate of return superior to what shareholders could probably achieve themselves, a full distribution of profits is in the shareholders' best interests. Thus a company paying a high dividend might not be indicative of a successful enterprise. Rather, it might reflect a management faced with no suitable options for the investment of new capital.
  • When best dividend is no dividend
    There are times when it is in the shareholders' best interests for no dividend to be paid. If management has the capacity to invest new capital at rates of return higher than the investor's required rate of return, then wealth will be created by retaining profits within the company. This is the principal reason why Buffett has chosen for Berkshire not to pay a dividend.
  • Executive incentives
    The potential for further distortion of dividend policy lies in the use of options as a form of management compensation. If management holds call options and/or has its remuneration linked to an increase in the company's share price, there will be an incentive to retain earnings rather than pay them out as dividends. This might run counter to the best interests of shareholders, particularly if the retained profits are invested at low rates of return.
  • Accounting quirks
    Net profit after tax, as reported in the financial accounts, is often not a true reflection of what shareholders earn over an accounting period. Despite this, it is broadly used in valuation formulas and value-based ratio analysis. Indeed, most valuation articles and texts actively promote it as the figure to use. But a more appropriate measure of profit is that which remains after deducting the expenditures necessary to maintain the company's competitive position and its economic output.

    The accounts do not provide this figure; hence the investor or analyst needs to calculate it. By way of example, consider depreciation expense. Rather than reflecting the capital expenditure necessary to maintain the company's economic and competitive integrity, it is a figure defined by accounting principles. The depreciation expense is calculated by applying a defined depreciation rate to capital equipment which is recorded at historical cost. This will usually understate the cost of its replacement; hence accounting profit will overstate the real profit due to the owners. In an extreme example, a company could be going backwards in an economic sense yet still report an accounting profit.

    To this end, do not consider a dividend in terms of the reported net profit after tax. Rather, consider it in terms of what the company can afford to pay while maintaining its economic and competitive integrity.

Tax considerations

Fortunately, the impost of double taxation on company earnings was removed in 1987 by the Hawke/Keating Government. Dividend imputation is not enjoyed universally and this is one reason why there are lower payout rates in a number of other countries.

Australian retirees enjoy two extra benefits - the reimbursement of tax paid at the company level and the exemption of capital gains tax. It is interesting, therefore, to hear many retirees state their preference for dividends as a source of income. But because neither earnings nor capital gains are taxed in their hands, retirees should be indifferent, from a tax perspective, as to which they receive. If profits are retained and reinvested by a management capable of achieving high incremental rates of return on equity, then the returns from capital gain potentially outweigh those from dividend distribution.

Countering this argument is the issue of market volatility. Retirees are loathe to sell shares when sharemarkets are depressed and this might explain their preference for dividends as a source of income. But as long as a significant buffer of cash is maintained, their preference for dividend income should be reduced because they now have greater discretion in the timing of sales.

Finding high-yield companies

Selecting a portfolio of shares based on dividend yield alone has been shown to be a useful "scattergun" approach to investing. One investment technique that uses this approach is "The Dogs of the Dow". These broad dividend strategies work because share returns are based not on earnings growth alone but also on growth relative to expectations. Investor pessimism results in a low market valuation, which in turn results in a higher dividend yield. Thus investors are offered the potential for improved capital gain as well as a high dividend payment during the time they hold the shares.

But the sophisticated stock-picker should look beyond a selection process based solely on dividend yield. In the search for companies capable of delivering a strong, reliable and growing dividend, investors should look for those that demonstrate:

  • Strong underlying business fundamentals
  • Low debt and good business prospects.
  • Control over the price of the products and services they provide
  • A history of double-digit growth in earnings per share
  • Consistently high returns on equity (more than 15 per cent)
  • A dividend policy that is consistent with the company's underlying earnings
  • Growing book value (the carrying value of assets).

And avoid companies that:

  • Borrow to pay dividends
  • Have large and ongoing requirements for new capital simply to maintain their economic viability.

Remember, there are many excellent companies that do not pay high dividends. But make sure that management continues to invest retained earnings at high incremental rates of return.

About the author

Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer.

From ASX

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