There is something very attractive about receiving dividends. So much so that some investors and advisors base their whole strategy on seeking out stocks with consistent and growing dividends. There is, however, more to dividends since, amongst other things, they can be used to calculate the intrinsic value of a stock.
Before looking at the relevant calculation, let's examine some of the main issues surrounding the level and payment of dividends. There are two ratios that are helpful in understanding dividends, the dividend yield and the payout ratio.
Dividend yield is the total of dividends over a 12 month period divided by the stock price at the end of the period. It is a measure of the return on a stock purchase in terms of dividends without taking into account capital gains.
The payout ratio is the dividends divided by the net profit or earnings. A payout ratio of 0% means that the company is not paying dividends while a payout ratio of 100% means that it is paying all it earnings as dividends. Sometime the payout ratio will exceed 100%. Usually this only occurs when the company has suffered a drop in earnings but still wishes to continue paying dividends at a similar level to what it has done in the past.
In the USA, the average dividend yield for all the companies in the S&P500 index is 1.99% and the average payout ratio is 24.31%. In Australia, the figures are significantly higher, 5.14% and 42.24% for the group of companies in the S&P/ASX 200. The reason is due to the different ways that dividends are taxed in the two countries.
Dividends are paid from the profits of a company. For most countries such as the USA, they are paid from after-tax profits and the recipient is taxed on them again. This is referred to as the double-taxation of dividends.
In Australia the taxation laws are different and investors are allowed a credit for the taxation paid by the company when their own tax amount is calculated. This is called tax imputation. For this reason, Australian investors will strongly favor companies with higher dividends in order to get an associated tax off-set.
Without further analysis, often this is not a rational thing to do since frequently they will choose mediocre businesses with a high dividend yield while passing up on those companies that are likely to have a substantially higher capital growth. But the thought of getting something back from the government can be very tempting.
As we just said, dividends are paid from earnings. A company can do three things with the earnings or net profits that it generates. It can use all or part of them to expand the business either organically or by making purchases of other companies, it can buy back its shares, or it can pay the profits out as dividends.Â
If a company has opportunities to use its earnings profitably as measured by a high return on equity, then it makes financial sense for it to keep the dividends low or non-existent. On the other hand, if it does not see such opportunities, then it is better to pay them out as dividends.
The first mistake is for a company to keep its earnings and invest them in poor businesses. This is usually the outcome of management being over-confident with their abilities. It may be that the core business is successful so management believes that they can purchase other businesses and bring it up to a similar level of success.
Look for statements in the annual report stating that management has divested itself of certain investments to bring the company back to its core business. Invariably this means that hubris took control in the past resulting in a number of unwise purchases. Unless they make a frank admission that these past purchases were a mistake, there is a good chance that they will do it again.
The second mistake is for the company to insist on paying high dividends when they have clear opportunities to invest them profitably.
The third mistake is for a company to be overshadowed by its desire to maintain or increase its dividends every year no matter what the level of the earnings. If the earnings start to drop, this can result in higher and higher payout ratios, often over 100%. Even worse, it can result in the company increasing its borrowings in order to fund the dividends.
Intrinsic Value in Terms of Dividends: Dividend Discount Method
In the last article I talked about calculating intrinsic value as the discounted value of the free cash flow generated by the business. This is called the Discount Cash Flow Method or DCF Method. The Dividend Discount Method or DDM is similar except that free cash flow is replaced by dividends.Â
In formal terms, suppose that d1, d2, d3, … represent the forecasts of dividends of a business for years 1, 2, 3, … and so on. These dividends need to be discounted back to the present time to allow for risk and inflation. Let's denote the discount rate by r. (The actual rate is usually what is referred to as the weighted average cost of capital or WACC. It is calculated as the basic risk-free rate plus a risk premium.)
This means that d1 should be discounted by the rate r for 1 year, d2 should be discounted by the same rate for 2 years, and so on. Adding all these discounted values gives the present value or intrinsic value V of the stock, namely
V = d1 / (1 + r) + d2 / (1 + r)2 + d3 / (1 + r)3 + … = Σ dn / (1 + r)n,
where Σ signifies summation over n for years 1 to infinity.
This formula was introduced and examined in detail by John Burr Williams in his 1938 book The Theory of Investment Value.Â
Companies Must Eventually Pay Dividends
The first issue to consider are companies that have never paid dividends and look as if they will not pay any in the foreseeable future. An obvious example is Berkshire Hathaway. This company has not paid any dividends for the past 20 years; by everything written by Warren Buffett, its chairman and CEO, it is his intention to keep investing its earnings so successfully that, at least in his lifetime, it never will pay any dividends.
How can we apply the formula to companies such as this?
When you make a simple application of the DDM formula above, we get an intrinsic value of $0. At first this may appear contradictory. For example, Berkshire Hathaway is trading at a value over $130,000 which is the farthest from $0 of any stock..
However, when we make use of the greater fool theory, the contradiction disappears.
The greater fool theory in the stock market asserts that whenever you buy a stock, you can always find someone to buy it from you at a higher price, the so-called "greater fool". Accepting such a theory means that we don't have to concern ourselves with stock analyses and value estimates. For this reason, we reject the greater fool theory in purchase of stocks in a company.
As you will recognize, it is the greater fool theory that is behind all the major stock market bubbles. People continue to buy at inflated prices believing that they can always find another person (the "fool") who is willing to pay even more.
Returning to the issue of dividends, let us start with the assumption that everyone believes that a particular company will never pay dividends. When an investor buys stock, it is with the plan to eventually sell to another investor at some time in the future. (In some cases the intention may be to pass the stock on to heirs. In this case we will consider the family as the investor.) This second investor buys with the same intention, and so on.
Hence, without dividends now or in the future, any purchase is based on the assumption that all future purchasers will do so only for capital gains. But now we are in the grip of the greater fool theory. Each person buys because they believe that they can sell it for a profit to a "greater fool" since none of the purchasers believe that they will get any direct remuneration for holding the stock. Clearly this is untenable.
We conclude that every stock has a value based on the belief that it will eventually pay dividends even if it is only a single dividend from the liquidation or sale of the company.
Every stock has a value based on the belief that, even if it is not paying dividends now, eventually it will pay them even if it is only a single dividend from the liquidation or sale of the company.
This means that when using Dividend Discount Method to value a stock, even if it is currently not paying dividends, we have to make assumptions in the formula that after a specified time, dividends will be paid.
Free Cash Flow and Dividends
As we just saw, from the perspective of the DDM, ultimately it is the distribution of dividends to the stockholders that determines the value of the company. Hence, no matter how much free cash flow is generated, it is the anticipated reward to future stockholders from dividends that will determine the value.
The stream of free cash flow and dividends may, however, be quite different. For example, a new company may not pay dividends since it prefers to keep the cash to grow the business. Nevertheless, investors will invest in the company since they believe that ultimately the cash will flow through to higher dividends.
Warning Even though the above makes clear the importance of dividends, it should be seen only in an ultimate sense. Buying stocks because they currently pay a high rate of dividends without taking into consideration other factors including capital gains may be costly for investors.
Companies are aware that paying higher dividends is attractive to certain investors, particularly to retirees and those nearing retirement age. In some cases, management will exploit this tendency and deliberately pay dividends at a rate that could be damaging to the company in later years. For example, taking on extra debt in order to maintain or increase dividends should be a concern for careful investors. Also stocks with higher dividend yields may have lower capital appreciation so that the net gain is relatively low compared to the market.
Strengths and Weaknesses of Dividend Discount MethodsÂ
The strengths and weaknesses of the Dividend Discount Methods start with the lists as those for the Discount Cash Flow Methods in the previous article. For completeness, I summarize them here:
Strength 1: Clear definition The definition is quite specific in terms of the input variables and the calculations used to combine them. Under various assumptions the method is amenable to being programmed (as is evidenced by DDM in Valuesoft) and, with care, can even be calculated using a calculator of spreadsheet.
Strength 2: Rational definition A standard bond consists of a series of dividends plus the return of the face value at its expiration and its value is calculated as the discounted value of the dividends plus the discounted value of the face value. The definition of value of a stock using the DDM approach is a rational extension of the calculation of value of a standard bond.
A strength particular to dividends is that dividends are more concrete and direct than free cash flow and its variations. We call this Strength 3.
Strength 3: Dividend data is readily available The levels of dividends are easily obtained from the financial statements of a company and there is no dispute about them. In contrast, free cash flow usually takes an investigation of various entries in the accounts which may be specified in different ways for different companies. Also, there may be disagreement about which entries should or should not be included in the final determination.
Strength 4: Benefits from dividends are secure When a company pays a dividend of $1.00, you actually receive the payment and benefit from it. Alternatively, if the company invests the money back into the company, there is uncertainty about your receiving financial benefit from it. Hence there is more security in valuing a company via Dividend Discount Methods than those that use discount cash flows.
Another strength of the Dividend Discount Method in that it can be recast in what is called the Residual Income form. In this form it gives insight into new factors that increase or decrease the book value to give the final valuation. This variation will be examined in the next article in the series although, for completeness, we include it as Strength 5.
Strength 5: Residual Income The formula for the Dividend Discount Method can be modified so that the final valuation is given in terms of the book value plus the discounted value of the residual income generated by the company. This may be positive or negative and so may add to or subtract from the book value.
On the other side, just as for the DCF methods described above, the weaknesses of the Dividend Discount Methods include that they are theoretical, there are multiple formulas giving different results, they are unstable, it is impossible to verify some of the inputs, and infinite sums are used.
These are summarized as:
Weakness 1: Theoretical The first weakness is that they are theoretical formulas. Just because a stock has a high intrinsic value compared to its price, does not mean that it will be a profitable investment in terms of return. For example, it may continue at its current price levels. I think that it was Warren Buffett who said that a bargain is not a bargain if it stays as a bargain. Benjamin Graham talked about the "hazard of tardy adjustment of price to value".
Weakness 2: Multiple formulas There are many variations of the Dividend Discount Method using a variety of structures for the growth rates. The outcome is a range of different values. A stock could be undervalued according to one formula, but overvalued according to another.
Weakness 3: Instability All the formulas are unstable. This means that small changes in the input numbers lead to extremely large variation in the output. A change of a few percent in the input can lead to changes of 100% or more in the output.
Weakness 4: Untestable inputs It is impossible to test the accuracy of the key inputs in the formulas such as the terminal growth rate and the discount rate because they require forecasts out to infinity. More specifically, if I say that the long-term or final growth rate is 4% and you say that it is 6%, we can never determine who is correct since to do that we would have to wait for ever.
Weakness 5: Infinite sums As stated above, the DDM formula is an infinite sum. As such it requires an infinite number of inputs for the values which cannot be done one at time and requires them to be specified through a rule. This is a limitation on the values that are possible for the inputs. A second limitation is to calculate the value of an infinite sum we need to apply a mathematical formula. However, there are only formulas for a restricted number of infinite sums.
You can get more details in the article: The Value Imperative — Part 5: Intrinsic Value and Discount Cash Flow Methods
A further weakness is that the level of dividends paid by a company is at the discretion of the board. This means that two companies with similar business and economic characteristics could have completely different dividend policies ranging from no dividends to a 100% payout or more.
When making forecasts of, say, free cash flow, we start with the assumption that the business is always trying to maximize their level. As we just indicated, this is not the case with dividends. This means that it is very difficult to make any forecast regarding earnings, particularly when the time frame is longer than the expected tenure of the board and senior management.
This difficulty is compounded when a company has not paid any dividends for many years. To apply any of the Dividend Discount Methods in this case requires assumptions that (1) the company will start paying dividends in the future and that you can specify the time when they start and (2) you can specify the rate at which they will be paid.
We call this Weakness 6 and summarize it as follows:
Weakness 6: Dividend data is harder to forecast Because dividends are more under the discretion of the board and senior management of the company, they are harder to forecast, particularly if there has been no history of dividends being paid.
As for the Discount Cash Flow Methods described in the previous article, I think that the weaknesses of the Dividend Discount Method far outweigh its strengths. However, if you do wish to use either of these methods, you can get a practical implementation of them and many other methods through the software Valuesoft. Much of the above material is actually taken from the Manual of Valuesoft. In the seventh article in this series I am going to look at the Residual Income Valuation method, which is a variation of the Dividend Discount Method. It starts with book value and makes a series of adjustments based on return on equity and the payout ratio..
Before looking at the relevant calculation, let's examine some of the main issues surrounding the level and payment of dividends. There are two ratios that are helpful in understanding dividends, the dividend yield and the payout ratio.
Dividend yield is the total of dividends over a 12 month period divided by the stock price at the end of the period. It is a measure of the return on a stock purchase in terms of dividends without taking into account capital gains.
The payout ratio is the dividends divided by the net profit or earnings. A payout ratio of 0% means that the company is not paying dividends while a payout ratio of 100% means that it is paying all it earnings as dividends. Sometime the payout ratio will exceed 100%. Usually this only occurs when the company has suffered a drop in earnings but still wishes to continue paying dividends at a similar level to what it has done in the past.
In the USA, the average dividend yield for all the companies in the S&P500 index is 1.99% and the average payout ratio is 24.31%. In Australia, the figures are significantly higher, 5.14% and 42.24% for the group of companies in the S&P/ASX 200. The reason is due to the different ways that dividends are taxed in the two countries.
Dividends are paid from the profits of a company. For most countries such as the USA, they are paid from after-tax profits and the recipient is taxed on them again. This is referred to as the double-taxation of dividends.
In Australia the taxation laws are different and investors are allowed a credit for the taxation paid by the company when their own tax amount is calculated. This is called tax imputation. For this reason, Australian investors will strongly favor companies with higher dividends in order to get an associated tax off-set.
Without further analysis, often this is not a rational thing to do since frequently they will choose mediocre businesses with a high dividend yield while passing up on those companies that are likely to have a substantially higher capital growth. But the thought of getting something back from the government can be very tempting.
As we just said, dividends are paid from earnings. A company can do three things with the earnings or net profits that it generates. It can use all or part of them to expand the business either organically or by making purchases of other companies, it can buy back its shares, or it can pay the profits out as dividends.Â
If a company has opportunities to use its earnings profitably as measured by a high return on equity, then it makes financial sense for it to keep the dividends low or non-existent. On the other hand, if it does not see such opportunities, then it is better to pay them out as dividends.
The first mistake is for a company to keep its earnings and invest them in poor businesses. This is usually the outcome of management being over-confident with their abilities. It may be that the core business is successful so management believes that they can purchase other businesses and bring it up to a similar level of success.
Look for statements in the annual report stating that management has divested itself of certain investments to bring the company back to its core business. Invariably this means that hubris took control in the past resulting in a number of unwise purchases. Unless they make a frank admission that these past purchases were a mistake, there is a good chance that they will do it again.
The second mistake is for the company to insist on paying high dividends when they have clear opportunities to invest them profitably.
The third mistake is for a company to be overshadowed by its desire to maintain or increase its dividends every year no matter what the level of the earnings. If the earnings start to drop, this can result in higher and higher payout ratios, often over 100%. Even worse, it can result in the company increasing its borrowings in order to fund the dividends.
Intrinsic Value in Terms of Dividends: Dividend Discount Method
In the last article I talked about calculating intrinsic value as the discounted value of the free cash flow generated by the business. This is called the Discount Cash Flow Method or DCF Method. The Dividend Discount Method or DDM is similar except that free cash flow is replaced by dividends.Â
In formal terms, suppose that d1, d2, d3, … represent the forecasts of dividends of a business for years 1, 2, 3, … and so on. These dividends need to be discounted back to the present time to allow for risk and inflation. Let's denote the discount rate by r. (The actual rate is usually what is referred to as the weighted average cost of capital or WACC. It is calculated as the basic risk-free rate plus a risk premium.)
This means that d1 should be discounted by the rate r for 1 year, d2 should be discounted by the same rate for 2 years, and so on. Adding all these discounted values gives the present value or intrinsic value V of the stock, namely
V = d1 / (1 + r) + d2 / (1 + r)2 + d3 / (1 + r)3 + … = Σ dn / (1 + r)n,
where Σ signifies summation over n for years 1 to infinity.
This formula was introduced and examined in detail by John Burr Williams in his 1938 book The Theory of Investment Value.Â
Companies Must Eventually Pay Dividends
The first issue to consider are companies that have never paid dividends and look as if they will not pay any in the foreseeable future. An obvious example is Berkshire Hathaway. This company has not paid any dividends for the past 20 years; by everything written by Warren Buffett, its chairman and CEO, it is his intention to keep investing its earnings so successfully that, at least in his lifetime, it never will pay any dividends.
How can we apply the formula to companies such as this?
When you make a simple application of the DDM formula above, we get an intrinsic value of $0. At first this may appear contradictory. For example, Berkshire Hathaway is trading at a value over $130,000 which is the farthest from $0 of any stock..
However, when we make use of the greater fool theory, the contradiction disappears.
The greater fool theory in the stock market asserts that whenever you buy a stock, you can always find someone to buy it from you at a higher price, the so-called "greater fool". Accepting such a theory means that we don't have to concern ourselves with stock analyses and value estimates. For this reason, we reject the greater fool theory in purchase of stocks in a company.
As you will recognize, it is the greater fool theory that is behind all the major stock market bubbles. People continue to buy at inflated prices believing that they can always find another person (the "fool") who is willing to pay even more.
Returning to the issue of dividends, let us start with the assumption that everyone believes that a particular company will never pay dividends. When an investor buys stock, it is with the plan to eventually sell to another investor at some time in the future. (In some cases the intention may be to pass the stock on to heirs. In this case we will consider the family as the investor.) This second investor buys with the same intention, and so on.
Hence, without dividends now or in the future, any purchase is based on the assumption that all future purchasers will do so only for capital gains. But now we are in the grip of the greater fool theory. Each person buys because they believe that they can sell it for a profit to a "greater fool" since none of the purchasers believe that they will get any direct remuneration for holding the stock. Clearly this is untenable.
We conclude that every stock has a value based on the belief that it will eventually pay dividends even if it is only a single dividend from the liquidation or sale of the company.
Every stock has a value based on the belief that, even if it is not paying dividends now, eventually it will pay them even if it is only a single dividend from the liquidation or sale of the company.
This means that when using Dividend Discount Method to value a stock, even if it is currently not paying dividends, we have to make assumptions in the formula that after a specified time, dividends will be paid.
Free Cash Flow and Dividends
As we just saw, from the perspective of the DDM, ultimately it is the distribution of dividends to the stockholders that determines the value of the company. Hence, no matter how much free cash flow is generated, it is the anticipated reward to future stockholders from dividends that will determine the value.
The stream of free cash flow and dividends may, however, be quite different. For example, a new company may not pay dividends since it prefers to keep the cash to grow the business. Nevertheless, investors will invest in the company since they believe that ultimately the cash will flow through to higher dividends.
Warning Even though the above makes clear the importance of dividends, it should be seen only in an ultimate sense. Buying stocks because they currently pay a high rate of dividends without taking into consideration other factors including capital gains may be costly for investors.
Companies are aware that paying higher dividends is attractive to certain investors, particularly to retirees and those nearing retirement age. In some cases, management will exploit this tendency and deliberately pay dividends at a rate that could be damaging to the company in later years. For example, taking on extra debt in order to maintain or increase dividends should be a concern for careful investors. Also stocks with higher dividend yields may have lower capital appreciation so that the net gain is relatively low compared to the market.
Strengths and Weaknesses of Dividend Discount MethodsÂ
The strengths and weaknesses of the Dividend Discount Methods start with the lists as those for the Discount Cash Flow Methods in the previous article. For completeness, I summarize them here:
Strength 1: Clear definition The definition is quite specific in terms of the input variables and the calculations used to combine them. Under various assumptions the method is amenable to being programmed (as is evidenced by DDM in Valuesoft) and, with care, can even be calculated using a calculator of spreadsheet.
Strength 2: Rational definition A standard bond consists of a series of dividends plus the return of the face value at its expiration and its value is calculated as the discounted value of the dividends plus the discounted value of the face value. The definition of value of a stock using the DDM approach is a rational extension of the calculation of value of a standard bond.
A strength particular to dividends is that dividends are more concrete and direct than free cash flow and its variations. We call this Strength 3.
Strength 3: Dividend data is readily available The levels of dividends are easily obtained from the financial statements of a company and there is no dispute about them. In contrast, free cash flow usually takes an investigation of various entries in the accounts which may be specified in different ways for different companies. Also, there may be disagreement about which entries should or should not be included in the final determination.
Strength 4: Benefits from dividends are secure When a company pays a dividend of $1.00, you actually receive the payment and benefit from it. Alternatively, if the company invests the money back into the company, there is uncertainty about your receiving financial benefit from it. Hence there is more security in valuing a company via Dividend Discount Methods than those that use discount cash flows.
Another strength of the Dividend Discount Method in that it can be recast in what is called the Residual Income form. In this form it gives insight into new factors that increase or decrease the book value to give the final valuation. This variation will be examined in the next article in the series although, for completeness, we include it as Strength 5.
Strength 5: Residual Income The formula for the Dividend Discount Method can be modified so that the final valuation is given in terms of the book value plus the discounted value of the residual income generated by the company. This may be positive or negative and so may add to or subtract from the book value.
On the other side, just as for the DCF methods described above, the weaknesses of the Dividend Discount Methods include that they are theoretical, there are multiple formulas giving different results, they are unstable, it is impossible to verify some of the inputs, and infinite sums are used.
These are summarized as:
Weakness 1: Theoretical The first weakness is that they are theoretical formulas. Just because a stock has a high intrinsic value compared to its price, does not mean that it will be a profitable investment in terms of return. For example, it may continue at its current price levels. I think that it was Warren Buffett who said that a bargain is not a bargain if it stays as a bargain. Benjamin Graham talked about the "hazard of tardy adjustment of price to value".
Weakness 2: Multiple formulas There are many variations of the Dividend Discount Method using a variety of structures for the growth rates. The outcome is a range of different values. A stock could be undervalued according to one formula, but overvalued according to another.
Weakness 3: Instability All the formulas are unstable. This means that small changes in the input numbers lead to extremely large variation in the output. A change of a few percent in the input can lead to changes of 100% or more in the output.
Weakness 4: Untestable inputs It is impossible to test the accuracy of the key inputs in the formulas such as the terminal growth rate and the discount rate because they require forecasts out to infinity. More specifically, if I say that the long-term or final growth rate is 4% and you say that it is 6%, we can never determine who is correct since to do that we would have to wait for ever.
Weakness 5: Infinite sums As stated above, the DDM formula is an infinite sum. As such it requires an infinite number of inputs for the values which cannot be done one at time and requires them to be specified through a rule. This is a limitation on the values that are possible for the inputs. A second limitation is to calculate the value of an infinite sum we need to apply a mathematical formula. However, there are only formulas for a restricted number of infinite sums.
You can get more details in the article: The Value Imperative — Part 5: Intrinsic Value and Discount Cash Flow Methods
A further weakness is that the level of dividends paid by a company is at the discretion of the board. This means that two companies with similar business and economic characteristics could have completely different dividend policies ranging from no dividends to a 100% payout or more.
When making forecasts of, say, free cash flow, we start with the assumption that the business is always trying to maximize their level. As we just indicated, this is not the case with dividends. This means that it is very difficult to make any forecast regarding earnings, particularly when the time frame is longer than the expected tenure of the board and senior management.
This difficulty is compounded when a company has not paid any dividends for many years. To apply any of the Dividend Discount Methods in this case requires assumptions that (1) the company will start paying dividends in the future and that you can specify the time when they start and (2) you can specify the rate at which they will be paid.
We call this Weakness 6 and summarize it as follows:
Weakness 6: Dividend data is harder to forecast Because dividends are more under the discretion of the board and senior management of the company, they are harder to forecast, particularly if there has been no history of dividends being paid.
As for the Discount Cash Flow Methods described in the previous article, I think that the weaknesses of the Dividend Discount Method far outweigh its strengths. However, if you do wish to use either of these methods, you can get a practical implementation of them and many other methods through the software Valuesoft. Much of the above material is actually taken from the Manual of Valuesoft. In the seventh article in this series I am going to look at the Residual Income Valuation method, which is a variation of the Dividend Discount Method. It starts with book value and makes a series of adjustments based on return on equity and the payout ratio..
