In more conservative times, companies were valued based entirely on their dividend policies. Investors know that you can’t fake a dividend; a company has the cash or it doesn’t. In 2001, fewer than 20% of non-financial companies paid dividends to investors. Two decades prior, nearly two-thirds of all publicly-traded companies paid a dividend.
So when should a dividend be a deciding factor in an investment?
Dividends in Academia vs. Reality
Financial academia lead investors to believe that dividend policies are unimportant. Either earnings can be returned in cash, returned through share repurchases, or simply held on the balance sheet. The net effect is supposedly zero – being completely efficient, the market should correct for more cash on the balance sheet or fewer shares on the public market.
In reality, I don’t think the case can be so easily made that this is true. Over time, companies that retain earnings in cash merely sit on an asset that investors would rather have in their own pockets, safe from overactive managers and poor stewards of shareholder wealth. More importantly, publicly-traded cashboxes are of little utility to investors who want to own publicly-traded companies, not publicly-traded savings accounts.
Dividends only become important, in my view, when the dividend serves as a catalyst for a company to realize a reasonable valuation. Whereas companies can quite easily remain undervalued when they choose to hold onto the cash they earn, Wall Street quickly perks its ears up at a large dividend payout ratio.
The simple reality is that many companies will be born on the public markets and ultimately die there. In between birth and death, their stock prices will wiggle up or down, but for investors who hold from IPO to bankruptcy, the only thing remaining will be the dividends received over the company’s life.
Ultimately, I think a dividend policy is most important when a company becomes a behemoth too large to be subject to private ownership. A company is supposed to be valued based on its value to a private owner.
So what’s the dividing line?
Inserting my own completely arbitrary value for companies that should pay a dividend, I like to think that any company with an enterprise value of more than $10 billion should pay a dividend. Enterprise value being the sum of the market capitalization and long-term debt.
Companies that have an enterprise value of more than $10 billion are significantly less likely to be taken private, a transaction which helps the company realize its full value and potential to a private owner. There simply isn’t a market for private ownership for companies this size. Think about Walmart (WMT), a company which vastly exceeds my arbitrary cutoff for dividend policies. It’s huge – so large that you could never find a single entity or individual who would buy the thing as a whole. The same is true of Apple (AAPL) – it’s a huge company that will never go private at its current size.
The only way for a public company to realize a valuation equal to what it would be worth to a private owner as a company that will never be subject to private ownership is…to pay a dividend. When companies pay dividends the economics are similar to a private ownership model. Owners receive cash flows from the business just as they would if they owned all of it.
Smaller firms are investable without dividends, seeing as activists can gain control of the company and potential suitors can more than afford to take them private to realize a business’s full value.
Dividends are Best when they Follow the Business
Investors have been disillusioned by dividends. While the earnings from a business are never consistent, dividend programs often aim to be.
Take Apple, for instance, a company which runs on negative working capital (it literally receives cash for an iPhone before it pays for the manufacturing costs), yet it plans to stick by a slow and steady approach to distribute only $40 billion of its cash on hand over the next 3 years in repurchases and dividends. Apple has $30 billion in cash in the United States it could return to shareholders right now, but it will instead defer to a later point in time despite the fact that dividend taxes could be headed higher in the future.
In a perfect world, companies with minimal cash use would deploy dividends with the highest annual payout ratio possible. In reality, investors should favor large cap stocks that have the highest payout ratios with management that favors immediate distribution of earnings. In small caps, the dividend isn’t as important if the firm is small enough to be taken private as capital on the balance sheet, once it grows sizable enough, will be a target for activists and private equity.
How do you look at dividends when investing?