Wednesday, April 15, 2015

Does Paying a Dividend Reduce a Company’s Value?

One of the biggest misconceptions about dividend investing is that the value of your investment decreases by the amount of the dividend you received. This is a logical fallacy that I hear time and again, and really makes me lose hope in the human race. The origins of the fallacy are that it confuses stock prices with stock values. If after reading this article you come up with the conclusion that I do not understand the concept behind ex-dividend date, then chances are that you are confusing stock prices with stock values.

There is a difference between price you pay and value you receive. One can easily find stock prices on the internet or in newspapers. Stock prices fluctuate widely, by going from exuberant highs to depressing lows.

The value of companies however does not fluctuate that much on a daily basis. I am referring of course to the intrinsic value of the business, which would be realized in an arms-length transaction involving the sale of the whole company. While it is quite possible to purchase quality shares at a discount to intrinsic value, it is quite rare that a private seller would dispose of his/her total stake in a company at a fire-sale price.

A company can decide to do several things with its cash. It can choose to reinvest the money in the business, it can share the money with shareholders or it can accumulate cash for some reason. If a company earns more than it knows what to do with, it makes sense that it would send any excess to shareholders in the form of dividends. If all internal business needs have been met, and profits have been reinvested only after meeting a sufficient return on investment hurdle, it makes no sense to keep any excess reserves in Treasury. If management keeps too much cash on hand, it is very likely that they will find a way to squander if, diworsify, in an effort to justify higher bonuses for themselves. If you disagree with me, chances are you need some learning to do about human behavior, greed, and incentives.

In the modern business environment of today, strong blue chips with strong earnings power do not need to retain all of their earnings. For example, a company like McDonald's cannot simply plow all of its earnings back into opening new stores or starting new products, because those things take time, because it wants to avoid cannibalizing sales at existing stores, and because of the laws of diminishing returns and competition. A company cannot simply go ahead and acquire other companies or competitors because of anti-trust regulations on monopolies, because the business cultures are different or maybe because it doesn't have the expertise to branch out into other industries. On a side note, according to the thick business books most acquisitions tend to produce mediocre results at best. If they do accumulate all profits, chances are they are afraid that the success has been short-term in nature, so they need reserves for when things turn sour. Perhaps those are not the companies to be investing in.

This is the central reason why paying a dividend, which comes from excess earnings, does not reduce the value of the business. The value of the business is the sum total of all earnings from today, until the end of time. If that cash to pay dividends was not needed, then it wasn't going to increase the "value" anyways.

The fallacy about the reduction in prices, that confuses price and value stems from the concept of the ex-dividend day. The ex-dividend date is the first day that a stock trades, at which point the buyer is not eligible to receive the latest dividend payment that was declared. As a result, the share price is cosmetically reduced by the amount of the dividend.

However, you should not focus myopically on the ex-dividend date either.  If you believe that markets are somewhat efficient, then you should likely also believe that participants expect this dividend to be declared every 90 days or so. In other words, a stock that just went ex-dividend, and which also pays a 90 cent quarterly dividend, you would reasonably expect that it would accrue a dividend payable of 1 cent/share every day for the next 90 days. In other words, a stock that sells at $50/share and pays a 90 cent quarterly dividend will sell at $50 on the ex-dividend date. However, the share should be worth $50 plus the amount of dividends accrued. One day prior to the ex-dividend date, we should have a $50 stock and a 90 cent/share dividend receivable. In fact, options markets incorporate the level of dividends in the pricing of these derivatives.

Therefore, I would think that equity markets incorporate dividend expectations into the current price as well. Shareholders of a company like Coca-Cola (KO) can reasonably expect a quarterly payment of 33 cents/share every 90 days. This translates into an accrual of roughly a third of a cent every single day. Between ex-dividend dates, investors who hold the stock merely accrue that 1/3rd of a cent every single day. On the ex-dividend date, this receivable is recognized in full, which is when it becomes visible to everyone else. So in other words, the stock market is a mechanism that discounts in the share price any future dividends that are paid on a regular schedule. When you have special dividends however, you see a rapid unlocking of value for shareholders.

This is how I described this situation in a previous article:

If we make an analogy with bonds, one would note that the prices for both bonds and dividend stocks are decreased by the distribution amount on the ex-dividend date. With bonds however, interest is accrued daily and when you sell the security before the distribution date, you still get a prorated portion of the distribution. For example, let us assume that an investor purchases a 6% bond that pays every 6 months. The bond investor would then receive $30 on a $1000 bond on June 30 and $30 on December 31. By Mar 31, the bond has accumulated an accrued interest amount of 1.50%. If the investor manages to sell the bond at some random price, say 100%, the investor would actually receive the proceeds from the price and the accumulated interest for a total gain of 1.50%. It is interesting to note that dividend haters always focus on the ex-dividend date when discussing their opinions that dividends are a wash, since they give you cash but reduce your stock price. In fact, dividend stocks probably also accrue the dividend amount over time. As a result, investors do not really “lose” anything when ex-dividend date comes. In fact, this is mostly a cosmetic change, since stock prices are not directly tied to fundamentals but to other factors. Because stock prices fluctuate all the time, what truly affects stock prices is earnings, economic expectations, inflation interest rates, investor sentiment. The fact that stock prices are trading “ex-dividend” doesn’t really show on stock prices, unless a large special dividend is being paid out. As a result, stock dividends are already “calculated” by the marketplace and added to the stock’s valuation.

It is interesting to think how dividends unlock value if you think about the following scenario. A company earns $1/share and sells for $10/share. Now, if that company distributed a $10 special cash dividend, it will not trade at $0. That is because it still has a $1/year in earnings power. Only a fool would sell this stock at $0.

Astute dividend investors know that merely stockpiling cash on a balance sheet does not result in any value for shareholders. If however there is an announcement that a $10 pile of cash will be paid out as a special dividend, this will unlock the hidden value represented on that balance sheet. In the example provided above, that $10 stock will likely sell for close to $20 after that special dividend announcement.

For example, Kroger (KR) closed at a split-adjusted $4.53/share on August 31, 1988. The company was paying a quarterly dividend of 3.50 cents/share. In September 1988, the Kroger company was being pursued by a private-equity firm. In an effort to fend off the private equity acquirer, Kroger announced a special dividend of $5/share, as well as a note payable to shareholders in the amount of $1/share. At the end of December 1988, the stock was selling at $1.11/share. Those two special dividends unlocked hidden value in the share price, which didn't really show up on August 31, 1988. The value of Kroger in the hands of a private buyer was about $7/share, which  was much higher than the share price. The special dividends for $6 unlocked this extra value for shareholders.

Another example I can provide relates to the special dividend payments from Costco from 2012 and 2015.

On November 28, 2012 CostCo announced special dividend of $7/share to shareholders on record from December 10, payable on December 18, 2012. The stock price rallied to close at $102.58/share on November 28, which was up from the close of $96.51/share on November 27. The stock closed at $98.47 on the ex-dividend date of December 6, and it had closed at 105.95 on December 5. In this case, the special dividend unlocked hidden value in the enterprise for shareholders.

On January 30, 2015 CostCo announced a special dividend of $5/share to shareholders on record from February 9, payable on February 27, 2015. The stock price rallied to close at $142.99/share on January 30, which was up from the close of $140.64/share on January 29. The stock closed at $149.09 on the ex-dividend date of February 5, and it had closed at 155.92 on February 4. In this case, again the special dividend unlocked hidden value in the enterprise for shareholders.

The real reason people get confused and start believing that dividends reduce intrinsic value (besides the fact that they confuse price and value) also stems from the fact that they focus on one event and ignore the whole picture. For example, in Coca-Colas's case, the company earns $2/year, and pays out $1.32 in annual dividends. The rest is reinvested in the business. In a going private transaction at a 20 times multiple, the stock would sell for say $40/share. It is the earnings stream that will provide a source of value for the buyer.

Those who focus only on the ex-dividend, miss the forest for the trees. This is because they ignore earnings power, which is ultimately what drives valuation of a business. Dividends are paid out of earnings. A company like Coca-Cola has a source of cash that is replenished each year at a rate of say $2/share. This means the company can earn $2 this year, then $2 or more next year etc. The earnings power of $2/share is replenishing cash in the corporate coffers each year, and dividends are paid out of those coffers.

A good blue chip business like Coca-Cola will generate excess cash flows to be sent to shareholders. Sure the company can accumulate cash, but then chances are that management will find a way to waste that cash and diworisify. Without the discipline on capital allocation that the dividend provides, shareholders could end up worse off since management will be very likely to squander that cash on corporate jets, golf course memberships, insane bonuses etc. Of course if someone focuses on academic models and chooses to ignore reality, the reality of people behavior in business, then they will keep missing the forest for the trees. And piling that $1.32/year in cash or risky projects might make shareholders worse off than receiving that amount in dividends.

So in essence, shareholders have two options. The first option is to receive a dividend in the amount of $1.32/share. The second option is for management allocate that excess cash of $1.32/share into projects of dubious value, to stockpile cash that might provide incentives for management to diworsify or squander the cash, or to have management pay themselves more because the company has so much cash that nobody knows how to deal with. The sad reality is that no good business can afford to reinvest all of its profits back into operations at good rates of return for extended periods of time. There is a rate of diminishing returns on investment. In Coca-Cola's case, they cannot merely double production and advertising and number of plants and hope that sales will double - it is quite possible that this could actually bankrupt the company. In addition, few companies can expand beyond their core expertise into some other unrelated field or industries. This is why you only have one Berkshire Hathaway but over 100 dividend champions out there.

Actually, the best types of businesses that have delivered the best returns to shareholders are those that distribute that excess cash to shareholders and look like they have a really small book value to outsiders. Those are the businesses that only require a small percentage of profits to be plowed back into operations for future growth. If you don’t trust me look at Clorox (CLX). ( on a side note, if you are reading this site and you don’t trust my work, then you should not read this site anymore)

To illustrate the point that dividends do not reduce the company’s intrinsic value, let’s look at the acquisition of Heinz by Warren Buffett and 3G capital in 2013. Heinz agreed to be acquired for $72.50/share on February 14, 2013. When Buffett acquires a business, he looks for consistent earnings power and then incorporates his assumption on the value of the company earnings estimates from today’s date until the end of time. That is how he probably got comfortable with the price of $72.50. The price of $72.50 represented the intrinsic value of the business to a private buyer. There were no other companies or persons that submitted offers for Heinz, which means that $72.50 was a good estimate of the intrinsic value for Heinz.

The company reported quarterly earnings of 99 cents/share on February 21 and a quarterly dividend of 51.50 cents/share on March 13, 2013. The dividend was payable April 10, 2013 to shareholders of record on March 25, 2013. The ex-dividend date was on March 21, 2013, when the stock price fell by a little less than the amount of the dividend. As you can see from the table below, the price of the stock fell at the ex-dividend date. However, the value of the business to a buyer like Warren Buffett was unchanged at $72.50/share.


After the stock price fell on the ex-dividend date, it started slowly creeping up towards $72.50/share by the end of April 2013. Again, while the price had decreased, the value of the business stayed the same. This is a concept that confuses many investors out there.

On June 7, 2013, Berkshire Hathaway and 3G Capital completed the acquisition of Heinz at the proposed price of $72.50/share. The price fluctuated all it wanted between February 14 and June 7, and a dividend was paid in the meantime, but this didn’t really affect the value of the business.

In conclusion, when a company pays you a dividend, the value of your investment is not really reduced by the amount of the dividend, because the earnings power is the same. A dividend is excess cash flow that company's management has determined that cannot be put to use at high rates of return above cost of capital. Therefore, retaining that excess cash would not have generated an increase in the business earnings power ( and an increase in intrinsic values).

Dividends come from earnings that the company paying them has generated. As a result, the dividend is directly connected to the company’s fundamentals. The stock price on the other hand is something completely separate from the underlying business in the short run and is determined by investor emotions in reaction to macro and micro factors. During a period of greed, investors may feel greedy enough to assign a high earnings multiple for a company. However, during a period of fear, many investors would be afraid to touch the company even with a rock bottom earnings multiple. This is why most dividend investors ignore stock price fluctuations, and invest in companies they would be perfectly fine holding for ten years even if the stock market was closed for ten years.

Full Disclosure: Long KO, CLX and BRK.B

Relevant Articles:

Dividends versus Homemade Dividends
How to never run out of money in retirement
Dividend Investing Misconceptions
Four important dates for dividend investors
Coca-Cola (KO): A Core Holding for Dividend Growth Investors

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