by elmads

Introduction

There is this perception in equity investing that companies who pay dividends are one of the best investments, while the ones who doesn’t are mediocre businesses. These two statements are both right and wrong, because a good company can either pay dividends or not.

A wonderful business doesn’t have anything to do with dividends. Instead, it all boils down to the management, on how they operate their business and allocate their resources.

Capital Allocation

Businesses will always have the objective to increase/maintain their sales & profit margins by finding methods to increase their market share, expand their product portfolios and/or services, reaching newer markets, expanding in other geographical locations and whatnot.

There are a lot of ways for them to tackle and achieve their various goals, but one important factor that will always be present across the board is the business’ ability to allocate their resources efficiently.

Capital allocation is a process of determining the most efficient strategy for an organization’s financial resources to maximize its profits. In turn, it optimizes shareholder’s equity, or to put it simply, it is to generate as much wealth for the owners of the company.

The infographics above is the flow of cash of a company. It is the flow from receiving their revenue until it arrives to its Free Cash Flow, which is the real cash earnings of a company. The next question then is this, where does the management allocate the Free Cash Flow they received? How does it go back to the owners of the company (shareholders/investors) and how do they use it to further grow their business?

There are 5 ways that a company can allocate their Free Cash Flow:

• Paying dividends to their shareholders
• Purchasing some of the shares of the company (Share buybacks)
• Paying off their debts
• Reinvest it back to the business operations of the company
• Acquire or Merge with another company.

In this article, we’ll focus in numbers 1 and 2.

Why do some Publicly Traded Companies do not pay Dividends?

When we become a shareholder of a business, what we actually own is not the assets of the company, but the earnings they generate. It is through dividends that we directly receive a part of its earnings. This dividends are not completely free, because it came specifically from the Free Cash Flow generated by the company.

Additionally, the board of directors of a company make the decision whether if; they will or will not distribute dividends to their shareholders, and if they will, in what amount.

That being said, not all companies pay dividends because that money came from their generated cash earnings. They have to weight if giving out dividends is a priority for the business or not. There are a lot of factors that the board of directors take into consideration before paying dividends, again this is also a capital allocation strategy.

Just like in an individual level where capital/monetary allocation is an integral part of personal finance. Let me give you an analogy, it ‘s regarding with your yearly Christmas salary bonus. What do you usually do with it? Isn’t it you always think and make a decision where to allocate that money, either for spending, saving, investing, or the mix of the three. That small yearly decision you make will certainly have a direct influence in your present and future finances.

Going back to companies. The corporate life cycle has an influence in a management’s decisions for paying dividends, but this is not always the case though.

Source: https://www.youtube.com/watch?v=53voe62q3DE

Let me give you a series of question to explain the simple relationship of the corporate life cycle and dividends.

1.) Do you think it will be beneficial for a start-up company, who still generates a negative cash flow, to give out dividends to its shareholders? if yes, then where do you think will they get the money to pay dividends to their shareholder if their free cash flow earnings are in the negative?

Go into debt? Well that’s an option, but how will they pay for the interest on debt if they are still unprofitable? Also, will this not put the company at risk of: firstly, not achieving the growth that they’re aiming for. Secondly, increase the risk of their bankruptcy.

2.) If you are a growing profitable company, and see great opportunities in your industry and sector. Is it not better to just reinvest majority of your free cash flow back to your business than to pay dividends? so that you could capture the growing percentage market of the industry, getting a large chunk of the market share.

3.) If you are a mature company, and have reached your estimated maximum market share that you could capture, or have reached the peak of your growth and is just maintaining your market dominance.

Is it not better to just pay dividends to your shareholders? because the accumulated cash over the years in your balance sheet will eventually lose its buying power, due to inflation, if not put into use? Also, it would probably be better for your stockholders to just reinvest that money in other assets and let it work for themselves, is it not?

These are a few questions of many scenarios, there are a lot of factors that need to be considered depending where company is currently at in the corporate life cycle.

Dividends

The piece of ownership we have in a company’s earnings are given to us via dividends. This is one of the passive income we receive when we invest in equities. I’ve discussed this in detail in my article “What Are Dividends?” see link below. 👇👇👇

What are Dividends?

However, as attractive dividend paying companies are, we do still get taxed for every time we receive the distributed dividends.

Most countries have 10% tax rate on gross dividend income.

Let’s say for example, we’ve received a gross dividend income worth $1,000 from our shares held in Company A. Our net dividend income will then be worth $900, due to the 10% dividend tax rate.

Some investors actually prefer the alternative way, other than dividend income due its taxes. And this is where share buyback comes into the picture.

Share Buyback

As the name suggests, it is where the corporation and its management decides to buy shares of their company that is trading in the stock market. In an investor’s point of view, we will not receive any income at all, unlike with dividends, but our shares of the earnings in the company increases in this process.

So what does actually happen when the company buys back their shares?

As the company buys back more of their shares in the stock market, the larger will be the percentage ownership of all the current shareholders of the company will have relative to the business’ earnings.

What happens is this, the number of shares circulating in the stock market reduces, because the company bought it. Therefore, the total number of potential shareholders, where some of the company’s earnings can be distributed, also lessen. This increases the earnings per shareholder.

Like with dividends, even if the yearly dividend pay-out amount stays the same, but the number of circulating shares outstanding decreases, then the individual dividends received by each shareholder will definitely increase, just like with the infographic I showed above.

Share Buyback is the complete opposite of Share Dilution. The former decreases the number of shares outstanding of a company, while the latter increases it. I’ve discussed Share dilution in detail in my article titled, “Beware of Share Dilution”, see link provided below.👇👇👇

Beware of Share Dilution

The advantage of share buyback is that we don’t get taxed if the company takes this path, because we don’t receive any monetary amount in this process. However, the downside is clear as day, we don’t receive any dividends in this method. What we get out from this is only the increase of the ownership rights we have in a company’s earnings. In short, we still don’t receive any money.

Its long-term advantage:
As the company reaches maturity stage (maintaining their market share dominance) – one good example is Coca-Cola, as they’ve reached their peak, captured a sizeable market share in a very saturated market – the company decides to distribute majority of their earnings back to their shareholders via dividends, as they won’t be able to grow their company anymore unlike decades ago. Furthermore, they will find it hard to reinvest and put all of their earnings to work due to their size as a company. This is why it is better for them to distribute a portion of their earnings to their shareholders, and in turn let their shareholders allocate that money for themselves.

Just imagine this scenario; you’ve invested in a company early on their life cycle (High Growth or Mature Growth stages), and this company during that time has been doing share buybacks. By them doing this, your chunk of your business ownership increases. As the business reaches maturity stage, they decided to distribute majority of their real cash earnings back to their shareholders. That would be a fat dividend pay out for you as the shareholder of the business. This is because the business will have larger earnings per share now than before, this in turn could also translate to a larger dividend per share income for you as the a part owner of that business.

TRIVIA: One of the most popular, if not the most popular, company who have been massively buying back its shares for more than a decade is Apple Incorporation. Though we all know how wonderful of a company it is, not everyone knows that their share buyback program has also been one of the factors that substantially pushed up their market price. This in turn, also increased the dividend return per share of its owners. 

Apple Inc management., bought an aggregate amount of $487 BILLION worth of their shares in the stock market in over a decade, from 2012-2021. In comparison, they only distributed dividends to their shareholders worth $117 BILLION within the same time period. 

Share Buybacks should be done with a Strategy

Share buybacks shouldn’t be just done for the sake of reducing the number of shares of a company. Let me explain this further.

Just like with retail and institutional investors, what all of us wants is to purchase a company equal, or better, below its intrinsic value. No one would want to purchase a stock at sky high valuations relative to its projected potential business earnings.

Let me give you an analogy of this by asking you a question. Would you like to buy an iPhone 14 Pro Max 128gb at $3,000 when the SRP is $1,099? you get the point. This is exactly the same with a company buying back their shares in the market.

The management of the business would know what is the value of their company, as they have the first hand information of their business operations, its sector, industry, the risks, their potential growth and the potential cash flows it can produce in the future.

With this in mind, they would have a rough estimate what should be their company’s market value, the intrinsic value of their business. And, when the shares of their company reaches the said intrinsic value, or if it further goes below it, that’s when it is a no-brainer decision to repurchase back the shares of their business in the stock market. This is a perfect win-win situation for both the company and its shareholders.

Unfortunately, not all managements do this mindful and strategic share buyback.

The Oracle of Omaha, Warren Buffett shared his thoughts about managements executing share buyback programs.

“When stock can be bought below a business’s value it is probably the best use of cash. Many management are just deciding they’re gonna buy X billions over X months. That’s no way to buy things. You buy when selling for less than they are worth. It’s not a complicated equation to figure out whether it is beneficial or not to repurchase shares.”

To Sum It Up

Understanding the basics of accounting is important as it is the language of business. What we only need here is to understand what the numbers say, this is for us to be able to read financial statements, and guide us to make an informed investment decision.

Furthermore, we should also be aware of the corporate life cycle, just like with us human beings, companies change their priorities as they age.

In equity investing, dividends are great way to achieve real cash investment returns. Yet, we have to remember that not all companies who pay dividends are good investments. We have to be aware where the company is currently at in the corporate life cycle. This is because, capital allocation changes through out the cycle, and giving dividends could either be a wise or poor decision for a company.

Share Buybacks are a magnificent corporate financial engineering method, where shareholders of a company will substantially benefit from it. Most notably, if the management efficiently repurchases the shares of their company at fair or undervalued levels relative to its business intrinsic value.

The best combination are, doing both buybacks at below intrinsic value, and increasing yearly dividends. Then again, this is not always the case, as growth and expansion of the company is always the priority. When the company and its management does well, so as the capital we have invested with them.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.