Why are dividends important for investors?

The only thing that gives me pleasure is to see my dividend coming in.” –John D. Rockefeller.

 

Why Dividends Matter

 

One of the best ways in which a company can update its shareholders of its progress is to inform him that they are pleased to credit dividends in his bank account. However, small the amount may be, it is bound to give a smile on the face of a shareholder.

Dividend is a share in the profit of a company distributed to the shareholders. Not all profits earned by a company are distributed as dividends. Decision to declare a dividend is a policy matter and the Board of Directors of the company take that decision. The decision has a crucial impact on the future of a company. The amount that is not distributed as dividends is retained by the company for its capital requirements, as money belonging to the shareholders, thus adding to the value of shares owned by them. It is not unusual for good companies to declare more than one dividends in a year (’interim dividends and final dividends). A company’s track record of consistent dividends over the years is one of the great indicators of strength of the company.

Dividends matter to the shareholders for the following reasons:

  1. Dividends reflect fundamentals:

While there may not be much of direct relationship between fundamentals of a company and the dividend payout, it still matters. Sometimes a profit making company may decide not to pay dividends; this could be for a host of reasons, chiefly that it has growth opportunities ahead where the money could be effectively utilised creating further wealth for the shareholders.

On the other hand, there are some companies, which will, in the absence of profits, would dig into past reserves to pay dividends. This is often done to show to the shareholders that all is well with the company.

Dividends distribution has a great impact on the psyche of the shareholders, some of whom do their fundamental analysis based on only one parameter: How much got credited into his bank account by way of dividends?

For an investor dividend is the only real thing, everything else is delayed gratification. A company which earns Rs 10 a share on a Rs 10 share, and distributer Rs 2 as dividend, has utilised the remaining Rs 8 for the future growth; it will fructify later, the future is uncertain and the future earnings would depend upon a host of internal and external factors. Rs 8 are not what matters for most shareholders, but Rs 2 that is real money.

  1. Dividend Yield:

Many investors watch the dividend yield as an indicator. Dividend yield is arrived at by dividing the dividend amount per share by the current market price.

 

Dividend Yield = Annual Dividends per share / Price per share

 

Let us dwell a little into this topic. I have listed some of the companies with highest dividend yield in India, based on the current market price ( as on 22nd Oct 2018)

 

COMPANY PRICE % DIV DIV YIELD
Gitanjali Gems 1.55 8 51.61
       
Ingersoll Rand 520.9 2,080.00 39.93
       
IOC 131.25 210 16
       
Pincon Spirit 5.2 7.5 14.42
       
Vedanta 215.15 2,120.00 9.85
       
Power Finance 81.55 78 9.56
       
21st Cen Mgt 26.3 25 9.51
       
REC 104.6 91.5 8.75
       
ILandFS 6.9 30 8.7
       
NALCO 67.8 114 8.41
       
SJVN 25.45 21 8.25
       
HPCL 212.55 170 8
       
Polyplex Corp 502 400 7.97
       
BPCL 273.5 210 7.68
       
Manaksia 39.3 150 7.63
       
Oil India 201 150 7.46
       
Chennai Petro 261.9 185 7.06
       

 

Some conclusions are obvious from the above statistics:

  1. Some of the highest dividend yielding companies are not necessarily the best of the companies. Gitanjali Gems, a company owned by fugitive Mehul Choksi shows a dividend yield of 51%. This looks too good to be true, because it is. This company is under scanner of the enforcing agencies for loan default and financial frauds. Presumably the dividend was declared before the scam broke, and pitted against the current price, which has fallen from Rs 104 to the present Rs 1.55, it shows absurd results.
  2. IL&FS is another company which went through troubled times, and the dividend yield looks higher for the same reason.
  3. Ingersol Rand has declared a whopping dividend of 2020% or Rs 202 per share. This is one off event, since in the past company has declared 30% dividend consistently. This results in higher yield in comparison to the market price. Further investigation might lead you to an attractive investment opportunity. Every ratio is a lead to something good, which needs further study.
  4. The list includes some good companies. High dividend yield coming out of some of these companies is a lead to market mis-pricing, Mr. Market might be temporarily pricing them lower, and it may be a great investment opportunity.
  5. Some companies are what are known as ‘dividend stocks’. Every year they continue to give high dividend yield. After a due study of the fundamentals, they may be a good investment opportunity.
  6. Some of the stocks in the list are Public Sector Undertakings (PSU’s). They often have high dividend yield because the market does not pay much pricing premium on them. They would also fall in the category of ‘dividend stocks’.

 

  1. Dividend Stickiness and Dividend Coverage Ratio

As discussed earlier, managements would often keep paying out the same or increasing dividends just to show to the shareholders that their company is growing. Even in the situation of lowering profitability, the dividend is likely to stick. This is known as stickiness of the dividend. For majority of the shareholders, the financial statements have no relevance and are to be consigned to trash can- computer trash can in the electronic era- in the first possible opportunity, but not before turning to the page which says, “The Board of Directors and pleased to declare a dividend of Rs XX per share”

Since most companies-except companies involved in large projects and exploration where revenue is erratic-usually stick to a stable dividend policy, a cut in dividend often causes panic in the market. It has sometimes to do with the psychology than economics. While steadily increasing dividend is a reassurance, constant dividend is also not looked down upon, but for a company which has been declaring a constant dividend, irrespective of the percentage of dividend per share, to suddenly say that for a particular year the company plans to declare lower dividend, is bound to set the panic button. It is not unusual for managements of struggling companies to borrow and pay dividends. (Legally speaking dividends can be paid only out of current or past accumulated profits)

 

A tool that the intelligent investor must use to find out what percent of profit is being distributed as dividend, and whether the profits are sufficient to cover the dividend, is what is known as Dividend Coverage Ratio, also known as the Dividend Cover. This simple tool can help a shareholder understand the robustness of a company, in terms of its capacity to service the shareholders’ equity.

 

Dividend Cover = Earnings Per Share / Dividend Per Share

 

Let us pick up a real life example.

 

EPS of ACC for the year 2018 is Rs 49, the company declared a dividend of Rs 26 per share.

 

The Dividend Cover = 49 / 26 = 1.88

 

Simply stated it means that for every one rupee of dividend paid, the company had Rs 1.88 available out of current year’s profit. After paying the dividend, the remaining about will be retained by the company as the shareholders’ funds. The higher the cover, the more confidence it should give to the shareholders.

 

  1. Dividends bring discipline

History shows that the more the cash a company keeps, the more it is likely to use it for executive compensation, and mindless diversification. In India, where majority of the businesses are headed -not by a professional manager-but by the promoter himself, the temptation to compensate himself to the detriment of other shareholders is not uncommon. Dividend acts as a balance.

Manipulation of the books, resorting to creative accounting to show a picture better than reality is not uncommon, again. But, dividend is actual money, that has to be paid, and is not merely a book entry, prone to manipulations. Dividend is reality; manipulation becomes more challenging when the company has to meet the obligation of dividend.

Dividends are an implied public promise by the management. Reduce dividend, and investors feel cheated, almost like a breach of promise. After all, it is only dividend that the shareholder would get from the company in terms of cash inflow; the capital appreciation would come from the market, when he sells off the share, and is only notional till shares are sold. Dividends carry a great deal of emotional value for the shareholders for this reason.

There is only one worthy exception: The Warren Buffett’s company, Berkshire Hathaway, which pays no dividends.

 

Why Berkshire Hathaway pays no dividends?

 

Berkshire Hathaway does not pay a dividend because its chairman Warren Buffett, believes it is more beneficial to allocate the company’s earnings in other ways. In particular, Buffett prefers to reinvest profits in things that allow his company to improve its efficiency, expand its reach, create new products and services as well as improve existing ones, and further separate itself from competitors. Buffett feels that investing back into his business provides more long-term value to shareholders than paying them directly because the company’s financial success rewards shareholders with higher stock values. While the company does not pay a dividend, it does however have a prudent stock buyback policy that works to put cash directly into shareholders’ pockets.

 

The company has paid only one dividend during his reign, in 1967, and Buffett later joked he must have been in the bathroom when the decision was made. Nevertheless, statistics give credence to Buffett’s stance that using profits to buttress the company’s financial position results in greater wealth for shareholders than paying dividends. Berkshire Hathaway’s profits increased by almost 700,000% between 1964 and 2014.

But that’s the stuff legends are made of. Now many investors would trust other managements like they trust Buffett.

 

 

 

 

©Dr. Tejinder Singh Rawal

Chartered Accountant

M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD

This content is copyrighted and no part of it may be reproduced without the consent of the author

 This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated

 

 

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