Warren Buffett has discussed extensively the good side, bad side as well as the analysis of the dividend policy of a corporation in his letters to shareholders. Is a good company one with higher dividend payout? Or increasing dividends year on year? Or a stable dividend in both good times and bad times?
Investors should realize is that all earnings are not created equal. Some great businesses can use little asset to generate large earnings, and some other businesses create same earnings but they have to use a lot of higher asset values. Particular with those that have high asset/profit ratios – inflation causes some or all the reported earnings to become meaningless. Buffett would like to call those earnings “restricted,” meaning that they cannot be distributed as dividends to shareholders if the business would like to retain its economic conditions. If those “restricted” earnings were being distributed, the businesses would lose the ability to maintain their unit volume or sales, long-term competitive advantage and financial strength, and eventually fade to oblivion unless more equity capital is put in.
We might think that those restricted earnings are giving the owners of the businesses no value at all. Actually it does, but in order to value it properly, it should be heavily discounted. And that lead to the action of management to reinvest all the earnings back into the business, no matter how poor its economic potential. Buffett has given the example of Consolidated Edison in the 1970s. “At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value, that is, every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value.”
That is for restricted earnings. How about the unrestricted variety? Should be retained or distributed? Which brings investors greater value? Warren Buffett believed there was only one reason for the retention of unrestricted earnings. Only when there is a reasonable prospect ,that either has been proven by historical evidence, or careful analysis into the future, “for every dollar retained by the corporation, at least one dollar of market value will be created for owners.” That means if the earnings retained produces incremental earnings at least equivalent to those generally available to investors in the market place.
Buffett has chosen the example of investors holding a risk-free 10% perpetual bond and each year and then electing to choose either taking 10% coupon in cash or reinvest into the bonds. In in any given year, the market rate on long-term risk-ree bonds (he meant by the Treasury) is 5%, the investors would definitely reinvest the coupon back into the 10% bonds in order to gain 10%. If the investors take the coupon in cash, they would go out in the general market and realize only 5% on his invested coupon. Only foolish ones would go for cash in the 5% market rate.
However, if the market rate is 15%, then why reinvest the coupon back into the bonds to receive 10% whereas investors could take the cash out, and then go to general market to obtain 15%? And by that time, the 10% bond would be available in the market at the very large discount. The investors could take the coupon in cash and buy the 10% bond at a cheaper price if they want to.
And that should be the similar analysis that owners of the business should apply into the decision of paying out or retaining dividends. Of course, those analyses would be different from bonds perspective, as it would be subject to error because the return on reinvested earnings has to be projected into the future, not an exact known for sure figures. It would be fluctuating figures with different probabilities. Owners must make the guess of average rate in the intermediate future. If the guesses have been made with high confidence, then the rest of the analysis become simple, only compare them with the prevailing market rates to determine whether those earnings should be retained or paid out.Also check out: (Free Trial)
Investors should realize is that all earnings are not created equal. Some great businesses can use little asset to generate large earnings, and some other businesses create same earnings but they have to use a lot of higher asset values. Particular with those that have high asset/profit ratios – inflation causes some or all the reported earnings to become meaningless. Buffett would like to call those earnings “restricted,” meaning that they cannot be distributed as dividends to shareholders if the business would like to retain its economic conditions. If those “restricted” earnings were being distributed, the businesses would lose the ability to maintain their unit volume or sales, long-term competitive advantage and financial strength, and eventually fade to oblivion unless more equity capital is put in.
We might think that those restricted earnings are giving the owners of the businesses no value at all. Actually it does, but in order to value it properly, it should be heavily discounted. And that lead to the action of management to reinvest all the earnings back into the business, no matter how poor its economic potential. Buffett has given the example of Consolidated Edison in the 1970s. “At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value, that is, every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value.”
That is for restricted earnings. How about the unrestricted variety? Should be retained or distributed? Which brings investors greater value? Warren Buffett believed there was only one reason for the retention of unrestricted earnings. Only when there is a reasonable prospect ,that either has been proven by historical evidence, or careful analysis into the future, “for every dollar retained by the corporation, at least one dollar of market value will be created for owners.” That means if the earnings retained produces incremental earnings at least equivalent to those generally available to investors in the market place.
Buffett has chosen the example of investors holding a risk-free 10% perpetual bond and each year and then electing to choose either taking 10% coupon in cash or reinvest into the bonds. In in any given year, the market rate on long-term risk-ree bonds (he meant by the Treasury) is 5%, the investors would definitely reinvest the coupon back into the 10% bonds in order to gain 10%. If the investors take the coupon in cash, they would go out in the general market and realize only 5% on his invested coupon. Only foolish ones would go for cash in the 5% market rate.
However, if the market rate is 15%, then why reinvest the coupon back into the bonds to receive 10% whereas investors could take the cash out, and then go to general market to obtain 15%? And by that time, the 10% bond would be available in the market at the very large discount. The investors could take the coupon in cash and buy the 10% bond at a cheaper price if they want to.
And that should be the similar analysis that owners of the business should apply into the decision of paying out or retaining dividends. Of course, those analyses would be different from bonds perspective, as it would be subject to error because the return on reinvested earnings has to be projected into the future, not an exact known for sure figures. It would be fluctuating figures with different probabilities. Owners must make the guess of average rate in the intermediate future. If the guesses have been made with high confidence, then the rest of the analysis become simple, only compare them with the prevailing market rates to determine whether those earnings should be retained or paid out.Also check out: (Free Trial)
