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Chapter 29: The Dividend Factor in Common Stock Analysis

·         A natural classification of the elements entering into the valuation of a common stock would be under the three headings

1.    The dividend rate and record

2.    Income account factors (earnings power)

3.    Balance sheet factors (asset value)

·         The dividend rate is a simple fact and requires no analysis, but its exact significance is exceedingly difficult to appraise. From one point of view the dividend rate is all important, but from another and equally valid standpoint it must be considered an accidental and minor factor.

·         In the years until 1925, the price paid for a common stock would be determined chiefly by the amount of dividend. A common stock investor sought to place himself as nearly as possible in the position of an investor in a bond or a preferred stock. He aimed primarily at a steady income return, which in general would be both somewhat larger and somewhat less certain than that provided by good senior securities. Even if one company had steady earnings and another company had irregular earnings, this had little impact on the price paid which is dominated by the dividend rate.

·         Graham questions the established principle of corporate management which subordinates the current dividend to the future welfare of the company and its shareholders. It is considered proper managerial policy to withhold current earnings from stockholders to either strengthen the financial position or to increase productive capacity. The typical shareholder would most certainly prefer to have his dividend today and let tomorrow take care of itself.

·         Graham questions the assumptions of the dividend policy

1.    It is advantageous to the shareholders to leave a substantial part of annual earnings in the business.

s  If a business pays out only a small part of the earnings in dividends, the value of the stock should increase over a period of years, but it is by no means certain that this increase will compensate the stockholders for the dividends withheld from them, particularly if interest on these amounts is compounded.

s  An inductive study would undoubtedly show that the earning power of corporations does not in general expand proportionately with increases in accumulated surplus (retained earnings).

2.    It is desirable to maintain steady dividend rate in the face of fluctuations in profits.

s  Stability is usually accomplished by paying out a small part of the average earnings. The question that arises is if the shareholders might not prefer a much larger aggregate dividend, even with some irregularity.

The main objection to the above is that stockholders receive both currently and ultimately too low a return in relation to the earnings of their property and that the saving up of profits for a rainy day often fails to safeguard even the moderate dividend rate when the rainy day actually arrives.

Gives the example of US Steel that earned a profit of $2.344 billion over the period 1901-1930 and retained $1.25 billon of it. Yet, a small loss over a 1.5 year period in 1931 was sufficient to outweigh the beneficial influence of 30 years of practically continuous reinvestment of profits.

Assuming that the reported earnings were actually available for distribution, then stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends.

·         Graham questions the accepted notion that the determination of dividend polices is entirely a managerial function, in the same way as the general running of the business. This is because the board of directors consists largely of executive officers and their friends. The officers want to retain as much earnings as possible to simplify their financial problems, expand business for personal aggrandizement to secure higher salaries.

·         Graham suggests European companies policy of paying out practically all earnings and any capital for expansion purposes be provided by sale of additional stock.

·         Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus (retained earnings).

·         Graham suggests that if an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than corresponding increase in earning power above standard. So if a stock is paying 5% div yield and 7% earnings yield and another company paying 4.4% yield, then the investor should demand an earnings of yield of perhaps 8% to compensate.

·         The dividend rate is seen to be important apart from earnings, not only because the investor naturally wants cash income from his capital but also because the earnings that are not paid out in dividends have a tendency to lose part of their effective value for the stockholder.

·         The principle for dividends should be for the management to retain or reinvest earnings only with the specific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income statement as necessary reserves, with an adequate explanation thereof. A compulsory surplus is an imaginary surplus.

·         Summary

s  In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much larger eventual earnings and dividends. In such instances the market’s judgment proves to be wrong in penalizing the shares because of their small dividend.

s  Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from additions to surplus. This happens because either (a) the reinvested profits fail to add proportionately to the earning power or (b) they are not true profits at all but reserves that had to be retained merely to protect the business. In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the additions to surplus turns out to be sound. A company earning $10 and paying $7 in dividends should increase the value of stock over a period of years. This may be true but at the same time the rate of increase in value may be substantially less than $3 per annum compounded.

s  The confusion of though arises from the fact that the stockholders votes in accordance with the first premise and invests on the basis of the second.

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