In his annual letter of 2012, Warren Buffett has touched upon the long debated issue of dividends: when they make sense and when they don't. Buffett has looked the subject differently and should add value to academicians and the investors. Definitely his readers and followers have much more to gain.
Simplifying the math
Buffett’s explanation is considered to be the best explanation that any one can give on dividends, which is well supported by simple mathematical examples.
Let me spell it out for you in the Indian context and make it even simpler.
Let’s say you own a business with a net worth of Rs 100 crore which earns a return on net worth of 20 per cent. In the first year of business your net worth becomes Rs 120 crore and if you sell this business at 1.5 times the book value, you get Rs 180 crore (1.5*120).
Now take another case, in the first year, rather than retaining the earnings of Rs 20 crore, you decide to pay 60 per cent or Rs 12 crore (20*60%) yourself in the form of dividend. Because of dividend payment the original net worth will grow only by the retained money -- that is, Rs 8 crore-- to Rs 108 crore. Now if you sell the business with same multiple (1.5 times book value) the business will fetch Rs 162 crore (108*1.5). So in the second scenario what the owner will get is market value plus dividend that is Rs 175 crore. This is three per cent less than the amount that will be realised in scenario one as the dividend part of the equation does not get the higher multiple as does the retained earnings. If the exercise is repeated for the second year the difference is 13 per cent. So, over a period of time, because the retained earnings are compounding, the net gain will always be higher in the first case, which is if the company does not pay dividends to owners.
Theoretically, here the dividends will only make sense for the investors if the dividend that an investor gets is invested in instruments that generate 20 per cent or higher returns.
Buffett instead has provided a different solution. Instead of accepting the dividend, the investor could sell the stock for the same amount that he or she would have received in the form of a dividend. The advantage of this is that one will get a higher amount. Let's bring the earlier example: instead of Rs 12 crore dividend the owner can sell shares to the extent of Rs 12 crore value (1.5 times book value), which will give 50 per cent more value for the same money that will be distributed through dividend. Sure, your stake will come down but then the value of the remaining stake will not be destroyed and over the period of time this way the owners could create more value.
What else companies can do?
In his letter he mentioned that a profitable company can allocate its earnings in various ways (which are not mutually exclusive). A company’s management should first examine reinvestment possibilities offered by its current business –- projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors. The companies which generate cash should look for various options that could add more value to the long-term economics of the business and create value for its owners. He also talked about the building economic moats, which is the most neglected area of businesses given the short-sightedness of many present-day business owners. Economic moat explains the sustainable competitive advantage that not only protects the future profits of the company but also helps in predictability of the business and secure growth. We can probably touch upon this latter in detail in the next blog.
