Why It Would Be Unwise For Firms to Boost Dividends

July 27th, 2010 by hackel Leave a reply »

I cite the following:

  1. As seen in the chart above, for the S&P 500 Index, dividends are currently being paid at near 20% of operating cash flows, which is the historical norm.
  2. Operating cash flows have been exaggerated due to corporate executives maintaining a tight lid on expenses and strict management of the balance sheet, especially working capital items.  To the extent such tightening is lifted in favor of growth opportunities, it would not be difficult to increase the dividend without borrowing. Expansion also requires additional working capital and other items necessitating cash, including additional labor (and benefits), and other support (including, legal, I.T.)
  3. If because of an “everyone else is doing it” attitude, dividends are increased with borrowings (lifting debt ratios), cost of capital will rise and stocks will become a riskier investment, reflected in continued wide swings in securities prices. Coming out of a severe credit crises, cash outflows that do not increase prospective cash flows are not advised.
  4. Firms should currently seriously consider (if financial flexibility exists), with free cash flow valuation multiples suppressed, making acquisitions within their core competency. Such value-adding acquisitions will add to return on invested capital and enhance shareholder value (presuming a comfortable safety margin exists in their analysis regarding the acquired assets or capital expenditures over their weighted average cost of capital).
  5. Dividends do nothing to enhance long-term shareholder value. If anything, dividends send a signal management is bankrupt in finding better uses for cash. And there are currently many excellent outlets for cash which would increase a firm’s spread between its return on invested capital (ROIC) and cost of capital. What’s Berkshire Hathaway’s (BRK-A) dividend yield again? Why? Because Buffet knows the real way to enhance shareholder value, and it’s not via payment of a  dividend.
  6. It’s also about time investors recognized the road to real wealth is through long-term capital gains, unless of course you operate a high frequency hedge fund, in which case  you can afford to buy a major league baseball team.  The evidence is clear: If firms give away their flexibility, they deny upside performance and increase downside risk.

Disclosure: No positions

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

Subscribe to CreditTrends.com by Email

For additional information and extensive analysis on free cash flow, cost of capital and return on invested capital, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

Advertisement

3 comments

  1. A.C. Cameron says:

    Interesting take on dividends. Essentially you’re saying dividends are bad; and would agree in some cases. But isn’t the whole pt. of owning a share of a co. to participate in both growth and profit. While it’s obvious that the top people in these companies get paid outsized salary/bonus wouldn’t it make sense to pay the owners too?

    While trading is obviously hugely profitable for hedge funds etc, you are not really a share holder. IF the co. grows i.e. stock up, then it’s a good co. but you can’t stay with it and share in true profits unless you sell. Seems backwards to me.

  2. Steve Scroggin says:

    What you say is true, but incomplete. A bird in the hand may be worth two in the bush, especially if you have the slightest doubts about the bush’s accountants.

    As an investor I seek a company that can earn better returns than I can and so make better use of cash flow than I can, but many companies have proven their ability to long report the appearance of success, without its substance.

  3. William Wood says:

    Dividends DO matter. Long run rates of return of dividend funds in Canada have been higher than pure equity funds. See PH&N and BMO.