Why do companies pay dividends?
You may be surprised that I’m asking this question; surely the answer is very trivial. Well, let’s take a look.
The accepted theory is that a value maximising firm will refrain from paying dividends whilst there are projects and/or acquisitions where earnings could be reinvested at high rates of return. When reinvestment opportunities evaporate, the firm can choose to return capital via dividends or share buybacks.
But often we notice that firms earning high returns on reinvested capital will still pay dividends. Given that this capital could be reinvested to generate much higher profits later, this action doesn’t appear rational. Note that this is before we take into account the tax benefits associated with long-term holdings!
There are many theories to explain this irrationality, but I tend to give more weight to one in particular, namely, that management will most often act to maximise the near term share price of their company. To explain how, we turn to behavioural finance.
A famous experiment offers participants a choice between two cash flows. The first being an immediate windfall of $50.00, the second being a windfall of $100.00; however, it will not be paid for one year. Despite the high return on offer (100 per cent), people still tend to prefer the $50.00 windfall now. This same preference I believe drives demand for dividends and managers can capitalise on this in order to maximise near-term share prices.
Now, I am going to offer you a similar hypothetical proposal:
Proposal 1. $100.00 paid into your bank account for 10 years.
Proposal 2. $0.00 paid to you for the next 10 years. At the end of the tenth year, you will be paid $3,115.00.
So what is the best proposal? You decide!
It would be great to see your comments below as well as the justification behind your choice.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Michael Horn
:
I like dividends for a few reasons.
A. As a self-funded retiree, I need income to live. Warren Buffet’s answer to this is that if I held Berkshire Hathaway, and needed some income, I could sell a few units and be pleased that the residual units would be worth more due to price increases in Berkshire Hathaway shares.
B. Companies soon run out of internal investment options, so unless they can find something new to absorb the money, they simply cannot keep up their historical ROE, and then they get tempted to go down the slippery acquisitions path, which leads to failure more often than not.
C. There are other growth constraints than capital. I always worry when companies grow to quickly. In an imperfect world there are sticking points – for instance the guy who a superb manager of a company employing 300 people, may be hopeless at managing 30,000 people, and if for various reason he remains as head of the company, it will fail. At a slower growth these glitches are more likely to be resolved.
D. Compounding growth at the rate of a high ROE is in fact impossible – the numbers get too big.
In summary, in many cases a dividend payout ratio of 50% leaves the firm with as much funding as it can comfortably digest. Where the marginal cost relative to marginal revenue is low, a much higher percentage can be paid, or diverted to share buybacks.
colin benson
:
Correct me if I’m wrong the, but the interest rate compounded annually appears to be approximately 41% p.a. which is a great return, so $3,115.00 in the future is better than the bird in the hand, not even the Montgomery fund can match that rate of return and if it is a $3115 gift, it’s tax free, even better.
Paul Friedrich
:
The answer clearly depends on at what stage of your investing life you are at.
If you need $100 income to live each year, you take option 1 and your capital is still intact to continue paying you $100 per year past year 10. But if you choose option 2 and the bulk of the income is paid in later years , say 5-10, your capital has eroded so markedly that the out performance is irrelevant.
Example. If $1500 capital was starting point for each option (a realistic 6.66% gross yield for Option1) and for each year you required $100 income, at the end of year 1, Option 2 has only $1400 left to generate the income. If the bulk of income came year 6-10 you may only have $1,000 capital at year 6 to generate the income, so at this point option 2 requires a 10% income yield just to break even with option 1. The point is, purchasing an investment for “expected” income can be dangerous if you need this income to live today.
Just sayin, not always cut and dried……
LUCAS
:
No one has asked what the counterparty risk is on this contract. That’s an important consideration too.
David Christensen
:
It seems we are hardwired to value certainty over uncertainty and the present over the future.
Bird in the hand is worth two in the bush
Meaning
It’s better to have a lesser but certain advantage than the possibility of a greater one that may come to nothing.
Origin
This proverb refers back to mediaeval falconry where a bird in the hand (the falcon) was a valuable asset and certainly worth more than two in the bush (the prey).
The first citation of the expression in print in its currently used form is found in John Ray’s A Hand-book of Proverbs, 1670, in which he lists it as:
A [also ‘one’] bird in the hand is worth two in the bush
By how long the phrase predates Ray’s publishing isn’t clear, as variants of it were known for centuries before 1670. The earliest English version of the proverb is from the Bible and was translated into English in Wycliffe’s version in 1382, although Latin texts have it from the 13th century:
Ecclesiastes IX – A living dog is better than a dead lion.
Alternatives that explicitly mention birds in hand come later. The earliest of those is in Hugh Rhodes’ The Boke of Nurture or Schoole of Good Maners, circa 1530:
“A byrd in hand – is worth ten flye at large.”
John Heywood, the 16th century collector of proverbs, recorded another version in his ambitiously titled A dialogue conteinyng the nomber in effect of all the prouerbes in the Englishe tongue, 1546:
“Better one byrde in hande than ten in the wood.”
The expression fits well into the catalogue of English proverbs, which are often warnings, especially warnings about hubris or risk taking. Some of the better known examples that warn against getting carried away by that exciting new prospect are: ‘All that glitters is not gold’, ‘Fools rush in where angels fear to tread’, ‘Look before you leap’, ‘Marry in haste, repent at leisure’, ‘The best-laid schemes of mice and men gang aft agley’.
Source http://www.phrases.org.uk
David Procter
:
It would depend on the return I could get on the $100. If I could get a better return some were else than waiting to get $3115 in ten years time I would go with the $100. If I couldn’t, I would go with $3115 in ten years time.
Richard
:
You would take the $3115, unless the $100 could be reinvested into the Montgomery Fund every year for all ten years :)
Roger Montgomery
:
Nice Richard. Thanks for the encouraging words…
Michael Brydon
:
Hi, I would have some of both. Why? Following this advice I sold out of NAB shares at $29.50 and Telstra at $4.65. The yield chasers chasing $100/year (in your e.g. have since pushed the price of NAB to above $33 and Telstra is now at $5.28. So timing counts for a lot when applying your advice. A time frame of 10 years implies value investing is a patient game. However given the regularity of calamitous events over the last 10 years, Natural disasters, war etc, I would wager with certainty that there will be more interuptions to the market. Market sentiment will continue to play a role with the result that the income offered by high yield stocks will continue to attract investors.
Roger Montgomery
:
Michael, firstly we don’t provide any advice. Second, in the examples we gave we compared high yielders to high growers. Had you sold NAB and Telstra and replaced with high-grower/low yielder, one presumes you may have actually been better off – which was the point of the hypothetical examples.
paul
:
that obviously depends on how often the $100 is paid for 10 years?
Greg McLennan
:
Haha! Good pick up, Paul.
Andrew Legget
:
In regards to your hypothetical, it would depend on the opportunity cost of each proposal. What is the interest rate at which i can reinvest the $100 at and what is the risk of the $3115.00 not being there in ten years time.
It is hard for me to choose anything but the 2nd proposal. Assuming a 5% discount rate and a really quick and rough calculation, the PV of proposal 1 is $772.17. The PV of the 2nd proposal is $1912.34 which is obviously superior.
As long as the risk of me not receiving the $3k does not increase to a point where the discount rate would push the PV lower than that of proposal 1 then i would continue to choose this.
I have a really bad feeling i may have messed up these calculations which might be a tad embarassing as i have done them hundreds of times correctly before.
As for the dividend discussion, i think they are too highy valued in Australia. I would much rather a company reinvest their profits into value enhancing projects as long as they exist and only pay dividends if it has no valuable use for them internally. If they can compound their earnings at 15-20% internally, then that is a lot better than the 3-5% i can get in a bank account and probably strill quite higher than i can get at any given point in time by investing in the market.
Matthew Tate
:
Proposal 2:
My reasoning being it would take roughly a 25% return p.a on the $100 paid into our account in proposal A to match the amount being distributed to us in proposal B after ten years, a 25% return p.a over ten years is hard to achieve, so proposal 2 for me!
Carlos
:
I guess a bird in the hand is worth 2 or more in the bush,
and some people need money now, especially retirees who use
dividends as their income.
plus people have a natural tendency not to trust future promises made by executives, particularly 10 years away….
Nick Oddy
:
Twenty per cent return, all funds reinvested, no adjustment for net present value – all just to break even! I think I know which I’d prefer.
Roger Gibson
:
I would wait the 10 years and take the $3115 at the end of the period. My maths is not too hot but I reckon $3115 future value is giving nearly a 25% return.