Tuesday, February 13, 2018

Benjamin Graham lesson 5 Quantitative analysis and dividends

Quantitative Analysis, dividends



Graham divides quantitative analysis for three parts:



  1. Dividend ratio and record
  2. Earning power
  3. Balance sheet factors



Dividends



Investors have two sources of income: dividends and capitalized appreciation. The former is measured by the difference between the price used for selling and buying. Shareholders make decisions about the dividends in the annual general meeting. The board of directors gives a suggestion about the dividend and the shareholders either approve or they don´t by voting about it. Shareholder´s interest is not always the same as the interest of the company. Long term investor should always ask himself:



”Can the company invest the money paid as a dividend to the business better than the investor himself can earn by reinvesting it, when you take taxes into consideration?”



Big dividend is a good thing, when the answer to the question is no. The answer to this question isn´t simple. Different businesses have different needs for capital. When you make an analysis, you have to evaluate how good is the dividend policy compared to the capital needed. Companies with lots of net debt cannot pay so much dividends as the companies with no net debt. Good businesses pay dividends and can increase the rate in the long-term. The other possibility is to buy own stocks under the real value of future cash flows.
Companies have three reasons not to hand out the current earnings for the shareholders:

  1. Strengthening the financial position of the company
  2. Increasing productive capacity
  3. Eliminating overcapitalization
First reason is for accumulating cash. When the management are not willing to hand out current earnings and increases its cash position, it delivers a message to the shareholders. This message is telling the shareholders that management can increase the dividends in the future. You have to analyse whether this cash could be invested in something else. You also have to check the track record of the previous cash accumulations of the management. Their signals may be completely wrong. In this case, there is always a possibility that the future earning power of the company doesn´t proportionately expand with the increasing surplus of cash.
Giving a small dividends starts from the assumption that the owner and the company have the same benefits. Capital surplus can be a benefit for the company, but for the owners´ benefits can be different. Sometimes, part of the capital surplus cannot be used to increase future earnings enough. Then, the owners lose a possibility to invest this cash to some other places. Future earnings potential is not completely correlated on the capital surplus. When the company retains a dollar into its capital, it has to create at least a dollar of added value in the future. When this doesn´t happen, all the extra dollars should be given to owners.
Directors can be the biggest obstacles in a rational dividends policy. Owners have to protect their rights. Usually, the board of directors make a proposal about the dividend for the general meeting. Mostly, owners are lambs who easily succumb to the proposal. This can cause wrong incentives to the directors to use the surplus in any way they want. For example, getting generous options programs. Many directors have also tendencies to expand their own sand boxes by using the surplus in acquisitions or some other ways that are too expensive for the owners. On average, Graham thought that dividends were the better option for the owners than accumulating surplus in cash. He thought that a company must use sufficient part from the profits to increase its earnings potential and dividends. If the dividends is small, owner has to demand an exceptional skill of reinvesting the retained surplus from the directors.

Some owners may benefit from the smaller dividend rate than others. Owners have different kind of incentives like different tax rates for dividends. Smaller dividend rate can keep stock price lower, because markets may not understand the benefits of smaller rates compared to other similar type of companies. Owners can also suffer from the rate that is too high, because reinvested profits are not creating new profits or the profits are obligatory reserves left to the company. Sometimes investors are confuse the real profits and these reserves, because they invest only to get dividends.

Owners should make wise decisions about dividends and not leave the profit sharing proposal for the directors. Sometimes there is a demand for special decisions. Sometimes it is wise to leave the profits for the company and other times it is not the smartest choice. Every decision is made in special circumstances. Every owner should consider profit sharing proposals from his/her own perspective and make a decision how to vote in the general meeting.

I hope you will check the dividend policy of the companies you are interested in investing. Think about how reasonable it is for the owners.



Have a nice week!



-Tommi T

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