Quantitative Analysis, dividends
Graham divides quantitative analysis for three parts:
- Dividend ratio and record
- Earning power
- 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:
- Strengthening the financial position of the company
- Increasing productive capacity
- 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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