Cash is king: dividends, stock buybacks, and a "golden rule"
Chapter 12 of "Getting a Better Class of Enemy", my investment book
I'm writing an investment book called "Getting a Better Class of Enemy - Money, Markets and Manias". As I write the chapters, they will be made available to paid subscribers to OfWealth. Previous chapters, along with the Preface and Chapter Plan, can be found by clicking on this link.
The reason for the title is that, as your wealth grows, there are a lot of potential "enemies" that will try to take it away from you. These are explained in Chapter 1.
"Money can't buy you friends, but you do get a better class of enemy."
Spike Milligan, Irish-English author and comedian (1918-2002)
The ability to generate cash and return it to investors, now or at some point in the future, is what distinguishes a good investment from a bad one. But far too many stock investors ignore this basic reality.
This latest chapter takes a closer look at the two ways that companies distribute cash: dividends and stock buybacks.
In the case of dividends, if you don't understand the mechanics of the payments and their effect on share prices, then you will probably draw incorrect conclusions about how your investments have performed. Or even about which investments to select in future.
When it comes to buybacks, the payment mechanics and effect on stock prices are very different to dividends. Buybacks can be a good or bad thing, depending on various factors. Unfortunately, skewed incentives encourage many CEOs to do stock buybacks even when they are a terrible use of company cash.
All is explained in the chapter.
As always, feedback from readers is encouraged.
Please send emails to ofwealth@substack.com
Chapter 11:
Cash is king: dividends, stock buybacks, and a "golden rule"
"Capital allocation decisions are amongst the most important decisions which management of companies make on behalf of shareholders."
Terry Smith, British fund manager, founder and CEO of Fundsmith
Ultimately, all investments are worth the entire amount of cash that they can or will pay to investors from here to eternity, expressed in terms of today's money.
There are various ways to value investments, and Chapter 14 will take a closer look at them. But all of them - explicitly or implicitly - involve assumptions about future cash flows, discounted at an appropriate rate of return.
By appropriate rate of return, I mean an annual hurdle rate that takes account of the riskiness of the investment. The hard part is estimating both the future cash flows and the hurdle rates. So it pays to make conservative assumptions.
In any case, this chapter will focus on the cash distributions actually paid by companies to investors in their common stocks (ordinary shares). These take two forms. The first is dividend payments. The second is stock buybacks, also known as share repurchases.
In my experience, far too many investors don't pay close enough attention to these cash distributions, which often generate a large part of the total returns from stocks. In some instances, they can even be the most important element of total returns, especially over long periods. For example, for stocks of low-growth, mature companies with very high dividend yields.
It's important to understand the dynamics of how both kinds of distributions are made, and also the effect that they have on investor profits. There are several nuances that could confuse investors at times. That could be in terms of how well a stock has actually performed since it was bought, or how attractive it is to own in the first place.
Let's start with dividends.
The dividend payment process, and its effect on stock prices
Within a portfolio, dividend income often makes up a significant portion of total returns for investors. This is especially true for investors that are focused on generating cash income from their portfolios, such as retirees. It's also especially true over long time periods.
The frequency of dividend payments can be quarterly, semi-annually, annually, or not at all - depending on the company in question.
The percentage share of profits directed to dividends is known as the "pay-out ratio", in financial jargon. Meanwhile the share of profits kept by the company is known as the "retention ratio". Thus, the sum of the pay-out ratio and retention ratio must always be 100%.
Many companies have clear dividend policies, and these vary considerably.
For example, Company A's management might say dividends will be 60% of reported post-tax profits in a year, with the interim (half-year) dividend being 30% of the prior-year's full dividend.
This is known as a "progressive" dividend policy, since its progress depends on the level of reported profits. Those profits are generally assumed to grow over time, but with some down years along the way. A progressive dividend policy allows for a company to reduce its dividend in a lean year.
Meanwhile, Company B's management might say "We will pay X per share after every quarter end over the next year", and update "X" once a year.
On the other hand, Company C might have no dividend policy, other than to pay out excess cash when available.
Company D may have a relatively low dividend-per-share, but one that has grown - or never been reduced - for many years, or even decades. That would show a commitment to reliable payments, although potentially at the expense of a low dividend yield, since the company prioritises dividend predictability over size.
Since there's so much variation, it's a good idea for investors in a stock to know the dividend policy of the underlying company.
It's also a good idea to know whether a company is likely to keep up the level of recent dividend payments, and/or grow them in future. A useful concept here is "dividend cover", which is the ratio of last year's profits to total dividends paid.
A company with annual net profit of $1 billion, and that paid $500 million in dividends over the last twelve months, has dividend cover of two times (200%). Profits would have to drop hard before the dividend was stopped, although it might still be reduced in a lean year (depending on the dividend policy).
Another company might have paid $500 million in dividends last year, but only made a profit of $400 million. In this case the dividend cover is only 0.8 (80%). If the profits were unusually low that year and likely to bounce back, or the company is sitting on huge cash pile, this may not be a problem.
But it's a major red flag if the company has big debts, and dividends have been paid by taking on additional debt, especially if that's something that's happened in several recent years.
The risk here is that the dividend will be cut severely in future, or cancelled completely for a time, until the debt pile can be brought under control. A stock that seems to have, say, a 10% dividend yield based on last year's payments might end up yielding far less in future, say 2% a year.
(In fact, stock investors would do well to avoid all companies with large and growing debts. This makes them far riskier, and there are plenty of better things to choose from.)
Whether a company can keep paying and growing its dividends is of course crucial. But it's also important that all stock investors understand the dividend payment process, which I’ll explain now.