Will’s Articles

Dividends

The Folly of Investing for Dividend Yields
(May 2004)

Investing for dividends is a fad that comes and goes. For example: “Investors, Dividends Rediscover the Love”, Wall Street Journal, April 15, 2004.
It is short sighted to invest for dividend yields – unless you really understand the impact of higher dividends on the future value of a company’s stock...There are no free lunches.

1. The long-term value of a company is the present value of all the cash inside it - the “Enterprise Value.” When a cash dividend is paid out of a company it is like taking a slice out of a piece of pie. The pie that remains is less – i.e. the Enterprise Value is less and therefore, the stock price will decline as it regresses toward the new Enterprise Value.

2. Interest payments on debt (such as loans or bonds) are different. When the interest payment is made out of the general cash of the company, the company still has a contractual obligation to pay the principal at a later date regardless of how much money is left inside the company for Shareowners.

3. There is another reason that dividends can hurt a company. Assuming that each dollar of new sales requires the same incremental investment in capital as the old sales, then the higher the dividend rate, the slower the company can grow sales (and related cash flow) without increasing debt.
The following model shows how to calculate the fastest that a company can grow its sales without increasing debt:

Maximum Growth Rate = Return on Equity x (1 – Dividend / Earnings per Share)

Example: Return on Equity (“ROE”) = 20%
   Earnings per Share (“EPS”) = $1.00
   Old Dividend per year = $0.25
   New Dividend per year = $0.50

Maximum Old Growth = 20% x (1 - $0.25/ $1.00) = 15%

Maximum Growth with New Dividend: = 20% x (1 - $0.50/ $1.00) = 10%

The impact of dividends is discussed in plain English Rich Shareowner, Poor Shareowner (Revised Edition). It is possible to estimate what a lower growth rate does to the stock price by substituting the new growth rate into the PEG table. The PEG table is described in both and Rich Shareowner, Poor Shareowner (Revised Edition) and Money Ain’t Free.