Dividends - boon or bane?

The Singapore Exchange recently posted a set of full year results for FY2008 at $478.3m, as opposed to Bloomberg's poll of $460m. This results came in slightly better than expected, mainly on the back of its growing Asian Gateway business, of which 45% of its revenue is generated from. The board decided on an increase in base dividend(the dividend which is guaranteed to shareholders) from 12cents to 14cents, with a base dividend of 3cents and variable dividend of 26cents announced this time round, bringing full year payout to 38cents.



This dividend yield, based on current prices assuming that you bought it on 08 August 2008, would have given you a dividend yield of 5.65%, which isn't too bad simply based on these figures. But it this a cause for joy, or rather, for concern for shareholders? Without poring through the financial statements for the year, I would like to express my views on dividend payouts as a whole and not focus on SGX.



A dividend payout is typically announced when the company has positive accumulated retained earnings, coupled with cash to pay out the dividend. Dividends are seen as a form of compensation for the volatility that shareholders experience during trying times like this, and at least provides some relief for shareholders of this high-beta stock. However, the burning question that all investors would, or should ask is: is this cash better off being invested in the business for organic growth, or dished out to shareholders?



To answer this question, I think one would need to go back to the basics of the role of the board. The board is elected by shareholders on a timely basis to maximise shareholder's benefits. To maximise shareholder's benefits of course would entitle increasing the holdings of the shareholder, and this would include both potential capital appreciation and dividends. So when should a company dish out dividends rather than invest them in the business? Typically, for every extra dollar of earnings/profits retained by the company for Year X, the returns generated in Year X + 1 need to be at least $1 as well?



To simplify things further, let's use this example. Say one day, you meet a guy on the streets who offers to help you earn money. You are tempted by this sweet offer, so what you do is you decide to give him $1 to see how much he earns from there. The next time you see him, he gives you back $2, an extra $1 which he earned for you. Being a smooth talker, he persuades you into giving him $1 out of your total $2 to earn something even more.



Now the question. Assuming that well, you were convinced of his prowess and thus decided to give him that $1 more, would you be satisfied with



a) a return of $1



b) a return of > $1



c) a return of < $1? Maybe what people tend to think of is that well, since this extra $1 is already something extra that I have earned on top of my original capital, it doesn't matter whether the return is less than what I invested. Based on this, c) is acceptable, while a) and b) are bonuses. So, assuming he returns you 50cents after investing your $1, your total holdings would now be $1(your base investment) + $0.50 = $1.50. And what did you have after the original 1st investment? $2. You wouldn't need to be a rocket scientist to figure out which is better off for you.



And, let's assume that the glib tongue in him manages to persuade you to to put this 'extra' 50cents with him to make more money, and you duly oblige. Judging from his 'prowess' and historical performance of 50cents for the dollar, he returns you 25cents. So now, your total holdings is $1(base investment) + $0.25 = $1.25. How's that for making money for you? You will never lose your original capital, based solely on this example, but you will never be making money as well. Wouldn't it then be much better if he had just given you that original $2 that he earned for you, and let you allocate this money yourself?(even buying an ice-cream with this money would give more emotional benefits than seeing this money growing smaller by the day)



The reason why I feel this is overlooked by some investors is because the example cited above is much more glaring whereas a chairman's statement of 'growing profits and revenue at a CAGR of quartrizillion % per annum' would have you believe that your money is in safe hands.



Now the biggest question of them all: is your board one of these people?



This paves the way for interesting ratios that I have not seen being used before, but I use frequently, like 'additional retained earnings-revenue' or 'additional retained earnings-profit', depending on your view on either. Of course, this metric is coined by me, so please please do not come throwing the ice cream that you have bought from example 1 on me.



Also, note that this does not apply for all cases. Sometimes, there are capital requirements set by banks and other debtors on the amount of cash holdings that a company should have, of course to protect their own asses(not a typo error) in the event that the company does a Houdini and runs away without paying off liabilities. Do check up on your company with regards to this. Also, there are other companies which are, or would have you believe, better off holding cash so as to capitalise on investment chances. Do be wary of such companies though, because acquisition as a form of growth, as opposed to organic growth, is normally not sustainable in the future and definitely less desirable due to complications associated with integrating two companies of inherently different systems. I shall not touch on that point for now, this rather much being subjective. Also, there are certain companies which require heavy maintenance capital expenditure due to the nature of the business. Whether this is good or not will not be discussed now either.

So, if you feel that the company is actually better off holding more cash for further acquisition or capital expenditure purposes, and am comfortable with giving a leeway(e.g. $0.70 for the dollar retained), do tweak your ratios. But an encouraging sign would be to see an increasing amount generated for the dollar retained, as it means that the amount you put in is increasingly making more money for you.

A similar, and much more popular, metric is the Return on Equity, which I fully subscribe to its usefulness. It is extensively used to measure the return to shareholders. However, the ROE encompasses other components like asset turnover, and even lowering debt would decrease ROE, so this metric may not be as useful or precise in comparison with the ratios mentioned above.

To make things simpler for investors like myself, I shall note down the points that I think need to be considered before investing in a company, and compile them into a list for future use. Shall start from now.

List of considerations 09 Aug 2008

1. 
   
   company must at least generate $1 (or close to) of revenue/profit for every $1 of extra earnings/profits retained.

Love to hear any comments and ideas to add to this list.