Dividends and Share price

[Drizzt]

By Dowz
B.ACC (2nd upper hons)
Provisional member of ICPAS

Dividends and Share price

Everybody loves an investment that gives that cash returns regularly, from cash back deals to cash rebates, Singaporeans have shown a penchant for everything cash.

For the purposes of this article, the main focus would be on dividends and the subsequent impact on share price.

Before the discussion proper, I have briefly listed down the several pros and cons of dividends

Pros of dividends

1. Good for income investors
2. Shows that at least the business is not fraudulent, able to give out cold hard cash
3. Returns money to investor when there is a lack of growth opportunities
4. Dividends give an alternative to valuation. Investors can use the dividend model to compute share price

Cons of dividends

1. Reduces sustainable growth rate*
2. Increases leveraging should dividends be given out for the sake of giving out dividends, where extra cash is needed
3. Better ways of ‘rewarding’ shareholders could be via stock buy backs

* see detailed discussion below



Dividends

It is my contention that dividends in fact, would not enhance the value of the shareholders than if the cash has been retained in the use of the business. The key assumption is that the company is able to generate the same or higher return on equity for the cash that is retained in the business.

Illustrative Example:

Assume a company, Company A, is able to generate a return on equity of 30% flat every year. 2 examples will be illustrated

For both scenarios,

* Average PE of company is 20
* Return of Equity is 30%
* Starting Earnings per share is $0.10
* Current Share price is $2.

Scenario 1:

Company maintains a dividend payout of 10% of profits.

Average PE : 20x

ROE: 30%

Dividend Payout Ratio: 10%

EPS: 0.10 cents

Current Share Price: $2.00

Future Share price: $17.19



We can see that based on the computations with the assumptions above, we have a final share price of $17.19 at the end of 10 years.

Scenario 2:

Company does not give a dividend and reinvest all the profits back into the business.



Average PE : 20x

ROE: 30%

Dividend Payout Ratio: 0%

EPS: 0.10 cents

Current Share Price: $2.00

Future Share price: $21.21



The share price in this case would then be $21.21 in this case.

What are the rates of returns for both scenarios?

For the company that gives out dividends, the annualized rates of return for the investor would be 24%. Not too bad. Taking the dividends into consideration, the total dividends would be $0.367 per share to the investor over 10 years. Hence total return would be $17.557.

Of course, we have not taken the time value of the dividends into consideration. Can the investor take the dividends and reinvest it themselves and generate much higher returns than 27%? Probably not. [Also, the amount of dividends have been taken to be considered as immaterial for the purposes of this article]

Without the dividends, the investor would obtain an annualized 27% return from the company.

To illustrate the power of compounding in the retaining of the dividends in the business, we stretch the number of investment years longer, to 20 years. Let’s take a look at the share price then

Scenario 3:

Dividends 10% payout, over 20 years, same conditions as above. We end up with a share price of $187.63

Average PE : 20x

ROE: 30%

Dividend Payout Ratio: 10%

EPS: 0.10 cents

Current Share Price: $2.00

Future Share price: $187.63



Scenario 4:

Dividends 0% payout, over 20 years, same conditions as above. We end up with a share price of $292.38.

Average PE : 20x

ROE: 30%

Dividend Payout Ratio: 0%

EPS: 0.10 cents

Current Share Price: $2.00

Future Share price: $292.38



For an investor with a long investment time frame, are dividends the way to go for higher returns? Or is it better if the companies retains the cash and reinvest it on the behalf of the investor?

Of course, which company can generate 30% ROE for 20 years? The best bet will be to follow the steps of Warren Buffett and pick companies with a good economic moat. That will be the way to ensure enduring economic success.

A SGX listed example would be Jurong Technologies. While this company is currently undergoing some difficulties, their track record has been around 30% ROE for the past few years. With a conservative dividend pay out ratio, the growth in share price has been nothing short of stunning.

Contrast that to a more staid business, Food Junction. While the business provides a high ROE, it presents little area for expansion which could be financed by their operational cashflow. Ostentatious spending of cash would impact margins and bottomline, hence their policy of a generous dividend payout. However, it can be deduced from their policy that because of this distribution, their sustainable growth rate is severely limited, which, given a constant PE ratio, reflects a rather stable share price.

Cum Dividend

There is also much speculation that if we buy a stock after the XD, we would be able to get a much better deal. Is that true?

The premise is that the share price will automatically rise back to its pre dividend price, hence, it will make a risk less gain.

Let’s examine that.

Investor A, purchases a stock at $1, CD, $0.1. After XD, the price drops to $0.9; Net portfolio to Investor A is $0.90 equity, $0.1 cash.

Investor B, purchases a stock at $0.9, XD. He gets the stock cheaper, but misses out on dividends. Is he better off than investor A?

Further, should the price corresponding rises to $1, both investor A and B are in the same position.

Price drop after dividends

Why would a dividend of 10 cents cause a corresponding decrease in share price of the company? The reason is that when we purchase a share, we are actually purchasing a part of the business. [a lot of people do not see the connection between the share and business, but that is another story for another day].

Suppose a business is made up of entirely $1 cash. How much would you pay for the business? Exactly $1. [for the sake of discussion, discard all potential earnings etc]. The business then gives out $0.1 as dividends. How much would we be willing to pay for the business? $0.9, since the worth of the business is lesser now.

Hence the thing to note that when we purchase a ‘cheaper’ share after dividends have been paid out, do not be mistaken that we are actually getting a bargain. The net effect to the investor is the same.

Conclusion:

Granted that the examples used are a little simple and uses several assumptions, which may or may not be very reflective of market conditions. However, it is my wish that this article could help to, if not to correct some misconceptions, at least to encourage investors to think more about the dividends they are getting.

*Disclaimer:

The idea of sustainable growth rate has been adopted from Mary Buffett in her book, “Buffetology”

[Drizzt]

thanks to dowz for his contribution.

[Starry]

well done

[swinger]

hi i'm newbie and i still dun get a conclusive point as to which is the best deal? buy before or after XD. pls enlighten?

[chantc]

If you're in for the long term, it doesn't matter.

If you're trading, or you're not sure of the company's prospects, most will buy after XD.

Sometimes when the price drop after XD, it overshoots.

[chantc]

Dividend plays are more for people of a different risk profile.

Some people think of the worst.

For e.g., based on your example, what happens when a bear market happens at year 17, and last until year 20?

What will then be the result?

[Drizzt]

the objective of the article is to illustrate the relationship between intrinsic share performance and div distrubtion.

you dun have to wait till year 17 to have a bear mkt. a profit growth of 20% per annum can take into consideration a bear market.

for illustration it is hard to come up with a realistic growth rate. in real life, growth rate can be even 300% in one year. How, do we factor in something that is hard to grasp? we have not much choice but to use an annual growth rate

[chantc]

I understand that part. I've nothing against the article, which is quite good by the way.

Just adding some views on why people think that dividend plays are the way to go. The article is more bias towards non-dividend plays. Maybe a more balanced view is better?

[ghchua]

Dear all,

I always hear about people selling a stock because they want to "take profit". Newspapers often always quote from dealers saying market is down because people are "taking profits off the table".

Actually, one can also view dividends as "taking profits" too. Since dividends is paid out of accumulated profits from the company, you are actually taking profits out of the company's reported profits every year, if a company consistently pay good dividends. This is better than selling part of your holdings, since you don't need to pay brokerage fees by receiving dividends.

After all, it is not wrong to take a profit right?

[DIY]

Dowz,



First of all must confess still newbie in stock purchase but may I seek your opinion on my observation on your analysis :
1) the question on giving out dividend or not will depends on whether the company is confident to make better use of capital.

2) for a growth company with substainable growth, the dividend will naturally be better kept to make the company bigger but I understand that all growth company will hit a plato or optimum point.

3) my humble suggestion ( and plse comment on my stock strategy ) is to buy dividend giving listed companies with consistant record. If there is no need for usage in dividend then put this amount into higher risk ( growth ) solid companies which I expect to get little dividend but more capital growth.

[chantc]

I think different people have different strategy in investment. Just find one that will allow you to sleep well.

[dowz]

Thanks for the support you guys have shown.
I've noticed that Drizzt did not mention anything about himself. So must credit him as well, he gave excellent ideas and edited my work as well

[dowz]

Hi DIY,
1) there are several reasons why companies want to give out dividends as well, and there is nothing to do with being investor centric.

They could be giving out dividends because the flavour of the month is dividend investing and companies that give dividends are accorded a higher valuation?

Also, their parent, or main shareholder are in need of cash, hence pressuring the company to give more dividends? [possibly Auric and FJ]

And there are reasons not to give dividends as well, perhaps their parent will be taxed at a higher rate? [think perhaps Isetan]

In general, i think we have to think and judge whether the company is being investor centric or being otherwised pressured

2) Agree that companies will hit a point where it's pretty hard to grow. IMO, i think the company can avoid giving dividends, but do a share buy back instead. In this instance, ROE will be maintained or increased, and investors who want to cash out, can do that easily.

[dowz]

3) my humble suggestion ( and plse comment on my stock strategy ) is to buy dividend giving listed companies with consistant record. If there is no need for usage in dividend then put this amount into higher risk ( growth ) solid companies which I expect to get little dividend but more capital growth.

thanks DIY,
IMO, i think it's better to have an objective of what you want to achieve for your portfolio and work towards it.

If you're looking for income, better to buy dividend giving stocks [note that dividend giving companies have to be stable, to ensure cash flow]

If you're looking for capital appreciation, ie, make your portfolio bigger, it is my humble contention that in the long run, seeking growth companies who know how to utilize their retained earnings will likely yield a better result.

A side note:
Even for income investors, i believe that there's a possibility for investors to select companies with great capital appreciation possibility

1) Dividend yield may be low. but if companies grow MUCH, a lower yield stock may still give out more dividends in absolute value if you purchased it earlier

2) If you need money, sell a part of the appreciated stock.

[dowz]

I understand that part. I've nothing against the article, which is quite good by the way.

Just adding some views on why people think that dividend plays are the way to go. The article is more bias towards non-dividend plays. Maybe a more balanced view is better?

I admit the article is biased towards non dividend plays

Just that i feel weird hearing people buy this stock because the companies give good dividends, so i just want to jot the thinking a bit, letting them know the other side of the story.

besides, no one says they buy the stock because it doesn't gives dividends right?

[chantc]

besides, no one says they buy the stock because it doesn't gives dividends right?

Actually, there are such people around. They refused to buy companies who give dividends. It just happens that these people are keeping quiet in the forum.

One's portfolio should have a mix of dividend, and growth plays. Let me say again that dividend and growth plays can be found too, just that its not easy to find them.

However, one issue is the selling of your stock to take profit. Other than poem's unit share market, there's no way to sell a little bit to take profit, unless you buy-in with a significant amount. With the minimum commission, the costs of selling a little sometimes will be too great.

[dowz]

One's portfolio should have a mix of dividend, and growth plays. Let me say again that dividend and growth plays can be found too, just that its not easy to find them.

that's the point of the article. For a growth play, it is more efficient NOT to give dividend

[donmihaihai]

Hi Dowz,

Pretty disappointed that you din push out the most important point. Growth or no growth, whether paying dividend of not, it depend on free cash flow.

By Dowz
B.ACC (2nd upper hons)
Provisional member of ICPAS


A SGX listed example would be Jurong Technologies. While this company is currently undergoing some difficulties, their track record has been around 30% ROE for the past few years. With a conservative dividend pay out ratio, the growth in share price has been nothing short of stunning.

And you point out a very good example, which is Jurong Tech. Initial high growth with high ROE, no free cash flow = no(little) dividends. So at the end of the day when growth mature, shareholder should get back their long due dividend or my making dividend(sale of share)?

I don't think that will happen or at least the current situation of Jurong Tech show. The initial high return in their contract manufacturing is gone with margin being compressed. That high return need high capital outlay with provided by cash and debts. As growth slow or no growth with margin being compressed, Jurong Tech try to look out for all kind of new revenues with increasing debt. ROE remain high but that is provided by huge increased in debt(more than one time equity compare to less than half time equity in the initial high growth period).

If the current situations continue,
1) Margin compression
2) All new contracts and business need new assets
3) Spending money to buy growth.

There won't be any free cash flow left at the end of the day. The best example is Jurong Tech is using their share as currency for acquisition at a time when their share price is being depressed.

[dowz]

thanks DMHH,
appreciate your comments, will take your points in when i revise this article.

When i was writing the article, the idea of free cash flow and how it affects dividend policy would require a few more pages... [capex, ROE, leverage etc].. my leave is ending, gotta start work again.... so....

Other than that, the simple objective of the article is only to show dividends and share price, and generating returns on retained cash affects share price.

[kanglc]

Good article Dowz.

After all these discussions on dividends, I had a short chat with my dad. I mention the pros and cons we discussed here about companies paying out dividends or utilizing the money for growth (my dad don't know what's a forum), and his view was that sometimes business runs into risk. Even strong, stable companies, or even government-linked companies may run into risk or losses in the future. We never know. A good dividend payout is assuring to investors, as a basic - at least I am getting better than risk-free investment, eg. fixed deposit. On top of that, any capital gain, you earn extra.

[bullrunner]

There won't be any free cash flow left at the end of the day. The best example is Jurong Tech is using their share as currency for acquisition at a time when their share price is being depressed.

Its interesting when u highlight this point... did jurong tech use their shares as currency for acqusition at a time when their share price was depressed? i think on hindsight, Jurong tech got the better end of the stick.. since the price now is much lower than when the aquistion took place. Chances are jurong tech knew that there will be more bad news before good news came and decide that its a good time to do acqusition when prices was still high relative to current price. If you look at it in this perspective you will realise perhaps they were helping shareholders after all..

BTW good article DOWZ.. one other new idea you might want to explore in coming up with the next article is that dividend rate itself might not be as important than dividend growth rate. Many people just look at the dividend per se but not the dividend growth rate which is also a vital part of calculating intrinsic value.

[dowz]

thanks for coming in bullrunner, since we are similarly vested in Jtech, we'd see if the worst is over!

Thanks, will note your comments when the article gets revised.

looking forward to more of your contributions over here, especially in the property discussions!

[dowz]

Good article Dowz.

After all these discussions on dividends, I had a short chat with my dad. I mention the pros and cons we discussed here about companies paying out dividends or utilizing the money for growth (my dad don't know what's a forum), and his view was that sometimes business runs into risk. Even strong, stable companies, or even government-linked companies may run into risk or losses in the future. We never know. A good dividend payout is assuring to investors, as a basic - at least I am getting better than risk-free investment, eg. fixed deposit. On top of that, any capital gain, you earn extra.

thanks kanglc for your comments, though i struggle to reconcile dividend investor with fixed deposit, since both are of different risk nature.

[ajahajah]

Hello, i enjoyed this article alot, and i think its very useful for me. Erm, but theres something i want to know which is the PE stated in your scenarios, do they play a part in the growth rate? Pardon me for being clueless!

[donmihaihai]

There won't be any free cash flow left at the end of the day. The best example is Jurong Tech is using their share as currency for acquisition at a time when their share price is being depressed.

Its interesting when u highlight this point... did jurong tech use their shares as currency for acqusition at a time when their share price was depressed? i think on hindsight, Jurong tech got the better end of the stick.. since the price now is much lower than when the aquistion took place. Chances are jurong tech knew that there will be more bad news before good news came and decide that its a good time to do acqusition when prices was still high relative to current price. If you look at it in this perspective you will realise perhaps they were helping shareholders after all..

Using inflated share price for acquisition is actually good for shareholder. Actually I din follow the share price and time of acquisition.

But coming from cash generating point, Jurong Tech does not have the cash generating ability for acquisition, especially in the last 2 years. Which mean they are being "forced" to use their shares as currency, big or small.

Other than that, the simple objective of the article is only to show dividends and share price, and generating returns on retained cash affects share price.

For you scenarios, maybe it is better if you add in the growth in NBV per share. As there is always an inseparable relationship between BV, ROE, EPS and growth. Perhaps when presenting in whole rather than per share basis give a better pic.

As far as I can see, many din get the relationship of ROE and growth.

I always think that you can do much better.