What defines a worthy stock for investment or retirement income? Unfortunately, for many investors, the answer is a stock that pays dividends. While dividends are a factor (among many) that can be used to judge a stock, it isn’t necessarily the most important or profitable determination to make when investing.
Furthermore, the world’s greatest investor and some Nobel Prize-winning economists both agree that a portfolio that focuses heavily on dividend-paying stocks is leaving money on the table.
In 2011, Warren Buffett’s Berkshire Hathaway announced they would be buying back shares in the company. Many shareholders wondered why their profits would be used this way instead of paying out cash dividends. However, some years later, in an annual shareholder’s letter, Buffet explained his position on dividends.
His opinion was that a company could do one of four things with profit:
- Reinvest in the company
- Purchase other companies
- Buyback shares
- Payout cash dividends
While the first three are certainly part of Berkshire’s strategy, Buffet explained what he saw as the disadvantage of dividends. Firstly, shareholders might require different levels of dividends. Secondly, dividends are taxed as income, which is disadvantageous for long-term investors. Finally, he was concerned that a dividend-paying stock could turn off potential investors who didn’t want a surplus cash payout.
To surmise a case laid out well in this article from 2013 by Sam Ro, Buffet spells out why dividends might not be the best way to generate wealth.
He postulates that suppose two individuals own a company worth $2m that earns 12% on net worth. This means a profit of $240,000 per year, which can either be taken out or reinvested (also accruing a 12% profit). Additionally, because investors are keen to buy into the company at 125% of the next worth, this means the value of what each owner has is $1.25 (total $2.5m).
However, if one shareholder wants dividends of one third ($80,000) to be paid out and two thirds ($160,000) to be reinvested in the company, this will result in an annual payout of $40,000 each. As the company grows, this 12% profit is split between dividends (4%) and reinvestment (8%), resulting in a net worth of $4,317,850 after ten years. By this time, the dividend would be $86,357, and each investor would own half the net worth, or $2,698,656.
While this is a fantastic outcome, Buffet suggests there is a more preferable and profitable method to consider. By leaving all earnings in the company and selling 3.2% of shares annually, the same $40,000 of returns would be earned in year one. However, after ten years, this sell-off scenario nets a return of $6,211,696 by compounding these extra funds.
By selling off shares annually, each individual’s ownership will decrease from 50% down to 36.12%. Still, because the company’s net worth is higher, the shares’ market value would be $2,804,425 — a full 4% greater than the dividend approach.
To further understand Buffett’s philosophy, we should take a look at Dividend Irrelevance Theory.
In 1961, Franco Modigliani and Merton Miller argued that a company’s dividend policy doesn’t affect its market value or capital structure. Instead, they believed that its stock price was determined by its ability to generate future earnings combined with its attendant business risk.
They stated that dividends don’t add value to a companies’ stock price, and furthermore, that dividends constitute a missed opportunity for reinvestment that, if anything, ends up harming a company.
Both men went on to win a Nobel Prize in Economics in 1985 and 1990. However, their theory — like all economic theories — has come under some criticism from those who feel that it falls short in a practical sense.
Yes and no. While dividends indicate how much cash a company is generating, they are not definitive, ironclad proof that a company is generating cash and sales.
As Steve Coker from Cedarstone Advisors points out, between 1995 and 2012, Apple Inc. paid no dividends yet generated billions of dollars for its shareholders. He notes that because cash was not exiting the company, reserves built up and increased the stock price, which benefited shareholders who still owned their percentage of this accrued cash. When analysing whether a company is a quality investment, dividends are important, but they’re not everything.
Taking all of this information together, what should investors do? While dividends are one of the factors determining how good a stock is, it is far from the only consideration a smart investor should make.
Instead of looking for dividend companies to generate income, investors are better served identifying stocks with good growth potential and then selling some shares to generate revenue.
Per Buffet’s calculations — and the work of two Nobel-winning economists — this is preferable to relying on a few percent of dividends when a stock could quickly drop by 10% or more. Also, it’s more profitable.
This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.