Show me the dividend!

In the years before the 1950s, all the texts about equity investment laid a clear emphasis on dividend. Benjamin Graham said that a conservative investor should consider only those companies that have been paying uninterrupted dividends for the last 20 years. The emphasis was evident not only on the presence of dividends. The quantum was considered important too. The Dividend Discount Model[1] was based upon the theory that a stock is worth the discounted sum of all of its future dividend payments.

Then came the era of growth companies. Companies like IBM and Xerox funneled all the returns from business back to it to fuel growth and paid little or no dividends. The only returns from such companies were from capital gains. It is important to note that this trend was a result of change in the mindset of investors, not the cause of it. The perception of investors has a bearing upon dividend policies of companies. The promoters want the price of their listed company to be higher than its value. A higher price enables them to raise extra capital when needed, raises a bulwark against hostile takeovers and gives a stronger currency to trade in during acquisitions. So what caused this shift in perception towards dividends?

If a company can earn higher returns on incremental capital addition than the rates investors can get in fixed income instruments, then lower dividends are better for investors. For example, Castrol generates 55.82% return on networth. If it pays dividends to me and I invest them in Fixed Deposits, I can get only 7%. Why should Castrol pay dividends and taxes upon it instead of deploying the cash into its highly profitable business? The answer depends on whether Castrol needs more capital or not. If it doesn't need more capital for business, even the company can't get high returns on idle cash. So it makes sense to pay out dividends.

At the same time, all the classic arguments in favor of dividends remain in force. As a matter of practice, companies maintain or increase dividend rates over the years. The declaration of dividend is an indication that the company expects the future earning per share to exceed the dividend per share. Dividends are harder to fake. Dividends also avoid bloated corporate structures with unprofitable diversification into non core areas. Dividends give the right to a shareholder to decide whether he wants to put the returns from capital into the same business or invest elsewhere (or consume). Finally, dividends remove the risk that the retained earnings will be blown away by some future act of foolishness (Citi Bank) or mischief by the management (Satyam). A bird in hand is worth two in the bush.

For a shareholder friendly board (!), it should be pretty easy to decide upon dividend. They know about the current capital requirements of business and available resources. They know about the future plans. If they have funds left after taking into account the capital required to handle contingencies and growth requirements they should release the money. If the company has high cost debt in its books, the debt should be paid first before paying out dividends. The earnings should not be retained unless there is a reason to do so.

Reality is very different, though. At least in India, I can see a whole lot of companies following dividend policies which are detrimental to the interests of shareholders. A few examples: Infosys Ltd, cash more than 2 billion dollars, produces 250 million dollars every quarter in free cash flow, zero debt, EPS 101.65 and dividend?? A paltry Rs 23.5 per share. They have no plans to invest this cash profitably and hence no reason to hoard but they do. Moser Baer, at the other extreme, is nose deep in debt with debt to equity ratio 1.32, interest cost 273 crores, loss per share Rs 21.6 and yet dividend Rs 0.6 per share. How much more stupid could one get?`The bottom line is this. The investors should analyze the company's profitability in conjunction with growth plans and outstanding debt to decide what percentage of profits they should get as dividend. If they get significantly more or significantly less than that percentage, the attractiveness of the company as a long term investment is questionable.


1. Dividend Discount Model

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