Do Dividend Plays Pay?

PERSPECTIVE | 12 MARCH 2010

Do Dividend Plays Pay?

By Aw Jie Sheng  

Dividends matter and they matter a lot! Had you bought Singapore Post at the start of 2005 and held it till the end of February this year, inclusive of dividends, it would have compounded at 9.4% over the 5 odd years, against the Straits Times Index’s 5.6%.

During that time frame, Singapore Post’s management had been very generous, rewarding a total $0.357 per share to its shareholders. Stripped of those distributions, Singapore Post would have lagged the market badly, compounding at only a paltry 3.4%.

This is not a case of cherry picking. In fact, a recent Citi Investment Research report noted that in the past 10 years, equities in Asia ex-Japan have generated a compounded total return of 5.9% per annum in US dollar terms, 46% of which came from dividends.

Dividend Matters


Some formulae are in order before proceeding further. Dividend yield, the most basic metric, is calculated by dividing total dividend per share paid out during a full financial year over the stock’s current market price.

Dividend payout ratio (DPR) is more instructive as yield tends to fluctuate depending on the time of the day. This is calculated by dividing total dividend per share paid out during a full financial year over that respective year’s earnings per share (EPS).

Singapore Post, for example, paid out a total of 6.25 cents in dividends per share, when EPS was 7.7 cents in FY09. Be sure to exclude special dividends as they are one-off. Dividend payout ratio works out to about 0.8, which means 80% of FY09 profits were returned to shareholders. The importance of the dividend payout ratio will be elaborated later.

There are companies, particularly those of blue chip pedigree, that have a formal dividend policy stating the percentage of operating or net profit to be paid out. This can be found under the CEO/Chairman’s statement section of the annual report.

Even though a dividend policy is a legally binding commitment, companies that have one loathe changing it, as a downward revision or omission of dividends generally signals financial woes.

Finding Dividend Plays


To be able to consistently return profits to shareholders requires disciplined management as well as strong cash flow on the company’s side. These companies tend to be larger and/or more mature and are found mainly in the banking and finance, consumer staples, utilities and energy sectors.

Those that do have consistent and high dividend payout ratios – so called dividend plays – are likely past their growth phase. The stability in their earnings is generally accompanied by lower levels of R&D and capital expenditures. This is where we return to the dividend payout ratio.

Take the company’s return-on-equity (ROE) and multiply it by the earnings retention rate, which is one less the dividend payout ratio, and you will get the sustainable growth rate (SGR).

Again using Singapore Post as an example, based on FY09’s ROE of 59.2% and earnings retention rate of 18.8%, its sustainable growth rate works out to around 11.1%.

The sustainable growth rate is helpful in gauging whether a company’s growth plan is realistic based on its profits but it will not tell you whether a company has the opportunity to grow.

In this instance, if the opportunity exists and should Singapore Post want to grow its FY09 earnings by more than 11%, it would have to increase its net profit margins (this increases ROE) or fund future investments with debt or the issuance of new stock.

Books To Read


Modestly named “The Ultimate Dividend Playbook” by Josh Peters and “The Future for Investors” by Jeremy Siegel are great books to read for ideas and strategies on investing in dividend plays.

Peters’ book is very comprehensive and provides a detailed explanation on how to select and formulate a portfolio comprising of dividend plays, and the underlying mechanics. Be forewarned “The Ultimate Dividend Playbook” might be too textbook-ish for some and that it is focused mainly on American companies.

Siegel’s more readable account is a must-read for investors worried about the how the impending demographic age wave in developed world would impact future asset returns. While repeating his argument that common stocks are the best asset class in the long run, he highlights the importance of dividends and stock valuations as well as including international stocks in your portfolio.

For non-bookworms, the table below lists a few companies with a history of consistent dividend payments as well as relatively high yields. As usual, more research on the reader’s part should be done before investing.


*As of 10 MARCH 2010 Noon

http://www.sharesinv.com/articles/2010/03/12/dividends-pay/

Buffett (1984): 'Investments in bonds' and 'Corporate dividend policies'

We saw Warren Buffett put forth his views on the concept of 'economic goodwill' and why he prefers companies that have a high amount of the same. Let us now see what the master has to offer in terms of investment wisdom in his 1984 letter to the shareholders.

While Buffett has devoted a lot of space in his 84' letter to discussing in detail, some of Berkshire's biggest investments in those times, but as usual, the letter is not short on some general investment related counsel either. In a rather simplistic way that only he can, the master gives his opinion on a couple of extremely important topics like 'investments in bonds' and 'corporate dividend policies'. On the former, he has to say the following:

"Our approach to bond investment - treating it as an unusual sort of "business" with special advantages and disadvantages - may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman's perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a "business" that earned about 1% on "book value" (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business."

Berkshire Hathaway in 1984 had purchased huge quantities of bonds in a troubled company, where the yields had gone up to as much as 16%. While usually not a huge fan of long term bond investments, the master chose to invest in the troubled company because he felt that the risk was rather limited and not many businesses during those times gave as much return on the invested capital. Thus, despite the rather limited upside potential, he went ahead with his bond investments. This is further made clear in his following comment:

"This ceiling on upside potential is an important minus. It should be realized, however, that the great majority of operating businesses have a limited upside potential also unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity - even under inflationary conditions, though these were once thought to automatically raise returns."

Years and years of studying companies had led the master to conclude that there are very few companies on the face of this earth that are able to continuously earn above average returns without consuming too much of capital. Indeed, such brutal are the competitive forces that sooner or later and in this case, more sooner than later that returns for majority of the companies tend to gravitate towards their cost of capital. If we do a similar study on our Sensex, we will too come to the conclusion that there are not many companies that were a part of the index 15 years back and are still a part of the same index. Hence, while valuing companies, having a fair judgement of when the competitive position of the company, the one that enables it to consistently earn above average returns is likely to deteriorate. This will help you to avoid paying too much for the company's future growth.

After touching upon the topic of bond investments, the master then gives his take on dividends and this is what he has to say:

"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas:

•  its ability to maintain its unit volume of sales, 
• its long-term competitive position, 
• its financial strength. 

No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused."

While the master is definitely in favour of dividend payments, he is also aware of the fact that not all companies have similar capital needs in order to maintain their ongoing level of operations.

• Hence, in cases where businesses have high capital needs, a high payout ratio is likely to result in deterioration of the business or sooner or later will require additional capital to be infused. 
• On the other hand, companies that have limited capital needs should distribute the remaining earnings as dividends and not pursue investments which drive down the overall returns of the underlying business. 
• In a nutshell, capital should go where it can be put to earn maximum rate of return.

He then goes on to add how his own textile company, Berkshire Hathaway, had huge ongoing capital needs and hence was unable to pay dividends. He also further adds that had Berkshire Hathaway distributed all its earnings as dividends, the master would have left with no capital at all to be put into his other high return yielding investments. Thus, by not letting the operational performance of the company deteriorate by retaining earnings and not distributing it as dividends, he was able to avoid a situation in the future where he would have had too put in his own capital in the business.

http://www.equitymaster.com/detail.asp?date=8/16/2007&story=1

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

Warren Buffett in his 1980 letter to the shareholders of Berkshire Hathaway:

"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."

The maestro made the above statements because in those days he felt that the prevailing accounting convention/standards were not in sync with a value based investment approach (Infact, they still aren't). In the paragraphs preceding the one mentioned above, he painstakingly explains that while accounting convention requires that a partial ownership (ownership of say 20%) in a business be reflected on the owner's books by way of dividend payments, in reality, they are worth much more to the owner and their true value is determined by the 20% of the intrinsic value of the company and not by 20% of the dividends that are reflected on its books. In the Indian context, imagine someone valuing a company like say M&M -if it had say a 20% stake in Tech Mahindra- based on the 20% of dividends that the latter pays out to M&M. This will be a rather incorrect way of valuing M&M, which in effect should be valued taking into account 20% of the intrinsic value of Tech Mahindra and not the dividends.

"The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise."

Buffett, as most of us might know, is a strong advocate of buyback, especially at a time when the stock is trading significantly lower than its intrinsic value and the above paragraph is just a testimony to this principle of his. Indeed, when stock prices are low, what better way to utilize capital than to enhance ownership in the company by way of buy back. The master further goes on to add that one can buy a portion of a business at a much lower price, provided there is auction happening. In other words, when there is a panic in the market and everyone is offloading shares, the chances of getting an attractive price is much higher. On the other hand, when there is a competition between two or more companies for buying another enterprise, the competitive forces will more likely than not keep the acquisition price higher, in most cases, higher than even the intrinsic value of the company.

http://www.equitymaster.com/detail.asp?date=7/12/2007&story=2

Make sure you have a steady cash flow when you retire

19 Mar 2010, 0139 hrs IST, Lovaii Navlakhi,


Retirement is the time when you hang up your boots from the hustle-bustle of daily life, relax, do your own thing. As we say, it’s time to say: "Goodbye tension, hello pension!” Suddenly, from the risk of dying too young, you have transformed yourself to the category where the risk of living too long exists.

The last thing you want to do is to have your money run out before you do. Risks have to be taken in a controlled manner, and post-retirement returns are thus assumed at 1% or maximum 2% p.a. over inflation. During one’s retirement days, the key requirement is safety, liquidity and tax-free returns. It is important to analyse the pros and cons of some of the avenues available to generate cash flow.

Rental Income 

Apart from a self-occupied property, all other real estate investments are made with the objective of either capital appreciation — like the purchase of land — or to generate return on investment, as in the case of rental property. 2008 has been a rude awakening, and we must prepare for the time when rentals may drop, and the property may remain vacant for a few months. Depending on rental income for 100% of one’s needs may be a risk that needs to be mitigated before heading into the retirement days.

Dividend Income 

A few weeks ago, a client approached me to plan some additional investments for his mother who was a retired senior citizen. He did not want to take risks with the investment and during the course of our conversation, we realised that nearly a third of her income was being received by way of dividends. So, while she was averse to risk investing, she was equally reluctant to reduce her shareholding because she was thrilled with the quantum of dividend that she would receive year on year. In this case, there is a need to reduce the risks that this client carries in her portfolio.

Annuities 

In all our retirement planning calculations, we assume a life expectancy of 85 years for males and 90 years for females. However, no one can say today whether that is an under-estimation or an overkill. To do away with this risk, one can consider purchasing of annuities which are paid for your lifetime, and on your expiry, to your spouse. Obviously, if one was to use this as the only source of retirement income, the quantum required to be invested would be large, so it’s best that about a third of one’s retirement requirement is met through this route.

Fixed Income Investments 

Returns on fixed income investments are normally taxable. For the purpose of planning, it may be best to consider these — like senior citizen bonds, post office schemes, fixed deposits — first so that the income is within tax exempt limit for senior citizens — Rs 2.40 lakh per year as per the latest Budget proposals. Practical examples abound which ensure income that is tax-free and carries minimalistic risk for the senior citizen.

(The author is the Managing Director and Chief Financial Planner of International Money Matters Pvt Ltd)


http://economictimes.indiatimes.com/Personal-Finance/Savings-Centre/Analysis/Make-sure-you-have-a-steady-cash-flow-when-you-retire/articleshow/5699880.cms

Sure and steady in volatile times - Investing conservatively means selecting good, dividend-paying companies.

By John Collett
February 3, 201

Conservative investing in dividend-paying companies will soften the blow of negative returns

Fund managers know and understand the benefits of capital preservation. They know negative returns are best avoided because of how difficult it can be to just get back to square one.

But ordinary investors probably don't appreciate the maths and the sort of high returns required to recover from losses. For example, a loss of 10 per cent requires a return of 11.1 per cent to get back to square one. A 20 per cent loss requires a return of 25 per cent and a 70 per cent loss requires a return of 233 per cent.

So big losses are likely to take a long time to recoup, which is why investing with an eye to avoiding losses in the first place is so important in growing an investment portfolio.

• That is particularly pertinent to the sharemarket because shares quite regularly lose 5 per cent or 10 per cent of their value and, occasionally, much more. 
• From the bull market peak of November 2007 to the bear market trough of March 2009, Australian share prices fell by more than 50 per cent. 
• While the Australian sharemarket has risen by about 45 per cent from the trough, it remains more than 30 per cent off its all-time high of November 2007.

However, the mathematics of capital losses say that for Australian share prices to return to record levels, share prices need to rise by almost 50 per cent from here. And that could take years, says the head of investment market research at fund manager Perpetual, Matthew Sherwood.

Sherwood cautions investors who, tempted by the easy gains, are considering throwing caution to the wind and going headlong into the sharemarket hoping to quickly recover earlier losses.

He says most of the easy gains on the back of the economic recovery have probably already been made.

"The best thing to do is to invest conservatively and reduce the risk in what is going to continue to be a volatile environment," Sherwood says.

Investing conservatively means selecting good, dividend-paying companies. A portfolio of income-paying shares helps take some of the sting out of the tail of the capital losses, he says. As economic conditions improve, so do dividends.

Fund managers tend to favour companies that pay consistently high dividends because of the fact that it helps smooth out the volatility of share prices for the investors in their funds.

Even when a company's share price is falling, it usually keeps paying dividends to investors. "Since 1882 the Australian sharemarket, on average, has returned about 12 per cent a year and half of that has come from dividends," Sherwood says.

The importance of dividends to Australian investors is not only that more of the total return from Australian shares is made up of dividends than is the case with overseas shares but that the dividends are favourably taxed in the hands of investors through our dividend imputation system.

The point for investors is simple. The best way for investors to get ahead is by having a well-diversified portfolio of consistently performing investments. That is likely to be a much more profitable route for investors in the long-term than holding a portfolio of investments whose returns are highly volatile and do not pay much by way of dividends.

Successful fund managers, such as Perpetual and Investors Mutual, have an investment philosophy that focuses on capital preservation and on investing in income-paying investments with the aim of delivering consistent total returns of regular income and capital growth.

Such an approach means the fund manager is unlikely to appear at the very top of performance league tables in any year but instead will provide the unit holders in their share funds with higher returns in the long run. Individual investors would do well to follow their lead.

The smoother ride provided by a lower-returning, income-paying investment will also help ensure investors stay invested.

Faced with significant losses, investors are more likely to take fright, sell their shares and put their money into cash, which in the long-term is the lowest-returning asset class of all.

Sticking with a portfolio that produces consistent returns has another advantage in that investors do not feel pressured to seek out the next big thing in the hope of making spectacular returns.

Trading not only takes up much more time, "churning" a portfolio also increases both transactions costs and taxes, particularly if the share is held for less than a year.

What you need to make to recover your losses
Cost    Loss    Price   Return
price   (%)     After   required (%)
                loss (%)
$100    5       95      5.3
$100    10      90      11.1
$100    20      80      25
$100    50      50      100
$100    70      30      233
$100    90      10      900
SOURCE: FAIRFAX

http://www.businessday.com.au/news/business/money/planning/sure-and-steady-in-volatile-times/2010/02/02/1264876022132.html

That a company earns a lot of money doesn't necessarily mean the stockholders will benefit.

That a company earns a lot of money doesn't necessarily mean the stockholders will benefit.  The next big question is:

• What does the company plan to do with this money? 

Basically, it has 4 choices.

1.  It can plow the money back into the business, in effect investing in itself.

• It uses this money to open more stores or build new factories and grow its earnings even faster than before. 
• In the long run, this is highly beneficial to the stockholders. 
• A fast growing company can take every dollar and make a 20% return on it. 
• That's far more than you and I could get by putting that dollar in the bank.

2.  Or it can waste the money.

• It can waste on corporate jets, teak-paneled offices, marble in the executive bathrooms, executive salaries that are double the going rate, or buying other companies and paying too much for them. 
• Such unnecessary purchases are bad for stockholders and can ruin what otherwise would be a very good investment.

3.  Or a company can buy back its own shares and take them off the market. 

• Why would any company want to do such a thing? 
• Because with fewer shares on the market, the remaining shares become more valuable. 
• Share buybacks can be very good for the stockholders, especially if the company is buying its own shares at a cheap price.

4.  Finally, the company can pay dividend. 

• A majority of companies do this. 
• Dividends are not entirely a positive thing - a company that pays one is giving up the chance to invest that money in itself. 
• Nevertheless, dividends are very beneficial to shareholders.

A dividend is a company's way of paying you to own the stock.  The money gets sent to you directly on a regular basis - it's the only one of the above 4 options in which the company's profits go directly into your pocket. 

• If you need income while you're holding on to the stock, the dividend does the trick. 
• Or you can use the dividend to buy more shares.

Dividend also have a psychological benefit. 

• In a bear market or a correction, no matter what happens to the price of the stock, you're still collecting the dividend. 
• This gives you an extra reason not to sell in a panic.

Millions of investors buy dividend-paying stocks and nothing else. 

• Compile a list of companies that have raised their dividends for many years in a row. 
• In Wall Stree, one company has been doing it for 50 years, and more than 300 have been doing it for 10. 

Evaluating Dividend-Paying Companies

A company should be evaluated on three dividend attributes:

1.  Reliable dividend payment history
2.  A record of increasing dividends
3.  A relatively high dividend yield

A company's dividend history is factored into the company's stock price. 

• One with a superior history of paying and increasing dividends will usually command a higher price than a company that has a poor record. 
• A high dividend yield will often attract more investors to a stock, and this can translate into higher prices as investors buy up shares to lock in a generous stream of dividends.
• A track record of dividend growth is an important indication of the company's ability to grow earnings. 

But beware of company with a high dividend yield that has an eroding earnings outlook.  Remember, a company can only pay dividends from current or accumulated earnings.  Without good earnings, there is good chance that the high dividend you covet may be cut.

What dictates dividend policy?

Management determines if it is going to distribute earnings in the form of a dividend or reinvest all earnings to further the business plan of the company.  The ratio of dividends paid out to investors versus the amount of earnings retained is called the payout ratio.  Changes in tax law and investor preference can influence decisions in the corporate boardroom regarding how much profit to retain or to pay out to investors in the form of dividends.  However, dividend increases often lag behind an increase in earnings because management will want to be certain that a new higher dividend payment will be sustainable going forward.

Looking back over market history, we can see that dividend policy and payouts have remained relatively steady and that any change in dividend yield has had a lot more to do with the change in stock prices than with changes to dividend policy made by corporate directors.  (Note:  You can 'price' your stocks by looking at historical dividend yields.)

Management is usually very reluctant to reduce dividends because a cut is often perceived as a sign of financial weakness.  Even during the Great Depression, companies were loath to cut dividends.  From 1929 to 1932, dividend yields soared because most companies maintained their dividends as stock prices collapsed in the crash.  But, as stock prices rose from 1933 to 1936, dividend yields fell - even though companies were actually increasing the dividends they paid.

This inverse relationship between dividend yield and price was really evident during the huge bull market run from 1982 to 1999.  Companies increased dividends steadily over the period, actually increasing dividends paid by almost 400 percent.  Yet the dividend yield collapsed to historic lows because stock prices increased by 1,500 per cent.

Some companies do run into trouble and cut or omit their dividend payments, but this is the exception rather than the rule. 

• The typical dividend-paying company not only maintains the dividend payout it establishes, but follows a policy of steadily increasing its dividend as earnings increase. 
• Some companies increase their dividend payments every quarter, some once per year, and others only as profits allow. 
• Some companies will even pay extra or special dividends if earnings have been quite good for a number of years.

Many established public companies pay cash dividends and have a dividend policy that is well known to their investors.  Some of them have been paying cash dividends for a very long time.

Twelve of the companies in the S&P 500 today started paying dividends more than a century ago.

S&P 500 Century Dividend Payers

Company ----  Cash Dividends Paid Each Year Since
Stanley Works ----1877
Consolidated Edison ---- 1885
Lilly (Eli) ---- 1885
Johnson Controls ---- 1887
Procter & Gamble ----1891
Coca-Cola Co ---- 1893
First Tennessee National ---- 1895
General Electric ---- 1899
PPG Industries ---- 1899
TECO Energy ---- 1900
Pfizer. Inc. ---- 1901
Chubb Corp ---- 1902
Bank of America ---- 1903

Price and Dividend Growth Trends of Share

Esso

in 1975
$1.5 Per share

end of 1983
$12.7 Per share

Capital gain
747%

Malayawata

in 1975
$1.5 Per share

end of 1983
$2.32 Per share

Capital gain
55%

Why is there such an enormous difference in the capital gain?

http://spreadsheets.google.com/pub?key=t43WD4CWVAy-DW46q0q892Q&output=html
 
 
What can we learn from the above table?
 
1.  We can see that both shares seem to sell at prices which fall within a range of dividend multiples which is fairly stable for each of the shares.   

• If we ignore the freak year of 1975, Esso appears to sell for a price that is between five and eleven times its dividend. 
• Malayawata, in contrast, seems to sell at a price that is between fifteen and forty times its dividend, except for the freak year of 1981. 

 
2.  We can see that the occasional freak year can take place when the prices move well out of the normal range.  

• In 1975, Esso was selling at a price that was far too low by its historical standard. 
• In 1981, Malayawata was selling at a price that was far too high.
• In the event, both prices have corrected themselves and moved back into the usual range within a year.

 
3.  We can see very clearly that the sharp increase in the price of Malayawata during 1981 was almost certainly due to speculation or manipulation. 

• The price rise could not be sustained in the absence of a big increase in dividend and the price fell back very sharply. 
• In sharp contrast, the price of Esso could be sustained even though the overall market dropped.  This was because of the very high dividend which was being paid out.

 
4.  We can see quite clearly that the Malaysian/Singaporean stock market is not an efficient one (i.e. one which prices shares correctly). 
 

• By all usual standards, Esso is a far superior company compared with Malayawata and yet, it continuously sells at a dividend multiple that is well below that of the latter.  
• This is very strong evidence that Malaysian investors do not always consider the fundamentals when purchasing shares.  To them, the stock market is more a place for a gamble than an investment.

 
5.  In eight years, the DPS of Esso increased from 18 cents to 140 cents, an increase of 678%.  It experienced an increase in the share price of about 747%.  This means that, nett of the dividend effect, the price of Esso went up by about 70% for the period examined.
 
In contrast, there had been a decrease in the DPS of Malayawata of about 25% and the price went up by about 55%.  This means that the nett of the dividend range, there was a price increase of 80%. 
 
This is roughly in line with the increase experienced by Esso after the dividend effect has been excluded. 
 

• Thus it is clear that dividend increase accounts for much of the price increase experienced by Esso while some other factors account for a small part of the increase. 
• Although Malayawata has experienced no increase in dividend, its price went up nevertheless due to the same factors which caused Esso price to go up more than the increase in dividend. 
• As to what factors these are, we are not yet in a position to answer.

 
Conclusion:
 
A careful study of the table provides evidence that the long term growth in a share's price is closely related to the amount of dividend it pays out. 
 
Over the short run, there may be temporary market aberrations which cause the price to reach unreasonable levels. 
 
But such madness is usually of short duration and within a year or two, the price will go back to its usual level.
 
 
Ref: 
Stock Market Investment in Malaysia and Singapore by Neoh Soon Kean

The concept of valuing a share according to its dividend

Hypothetical Company A:

EPS  30 cents (1987)  36 cents (1988)
DPS 15 cents (1987)  18 cents (1988)
Annual increase in dividend  20%

Assuming the intrinsic value of the share = 25 times its dividend (i.e. the dividend yield of a share should be 4%),  what should be the correct price of a share of Company A in 1987 and 1988?

Correct market price:
1987:  25 x 15 cents = $ 3.75
1988:  25 X 18 cents = $ 4.50

The intrinsic value of Company's A shares increased from $3.75 to $4.50 in a year, thus giving a capital gain of 75 cents or 20% on the 1987 price. 

•  This is exactly the same as the increase in dividend. 
• So long as the dividend of Company A goes on rising, its intrinsic value would continue to rise, thus providing its shareholders with continuous opportunity for capital gain.

To recapitulate:

• This does not mean that the market price would indeed be at these levels. 
•  It merely means that the price would be oscillating around these prices in the respective years. 

Question:  "But why should the price go up just because the dividend of a share has increased?" 

• The reason is quite simple.  If the price does not go up while the dividend keeps on increasing, the dividend yield of the share will become higher and higher. 
• Since the shares of Company A are traded in the same market as many other shares, its shares cannot sell at a dividend yield that is much higher than its competitors.  If its dividend yield is very attractive (i.e. very high) it will attract more buyers and its price would go up. 
• Similarly, there is no reason at all why the price of a share should rise unless it has a prospect of paying more dividend in the future.  Otherwise, its dividend yield would get out of place compared with the other shares. 
• This is why all too often, the speculative shares which are bidded up to stratospheric levels will eventually decline to their previous level. 

Summary:

The concept of valuing a share according to its dividend is a very alien one to most of the investors. 

Most would find it difficult to accept and may even think that it is too simple a concept to be true. 

However, the dividend yield approach works well as an investment tool over the long term. 
 
It is beyond doubt that over the long run, the price of a share is dependent on the amount of dividend it pays out.  The higher the growth rate of the dividend, the higher the growth rate of the share.

 

Importance of dividend yield in the evaluation of the worth of a share.

Shares should sell at prices which will provide their owners with a reasonable return. 

As an investment, shares have 3 characteristics:

1.  They are relatively illiquid.
2.  The return is uncertain.
3.  A large part of the return is in the form of capital gains.

Even the most inexperienced investor is aware of the last characteristic.

Question:  We should buy shares in accordance with their expected dividend yield (DY).  "If we buy a share for its dividend, why should its price go up so that we can get capital gains?"

Question:  "Why should the price of a share, any share for that matter, go up in the first place?"

 

Here are some reasons for share not to go up:

Share price should not go up as a result of reorganization.
Share price should not go up as a result of share split or bonus.
Share price should not go up as a result of property injection.
Share price should not go up as a result of rights issues.

There is only one good reason why a share's price should go up in the first place:

If one accepts the dividend yield approach to share valuation, the only reason why the price of a share should increase is that the share 

• now pays a higher dividend than before or  
• has the prospect of paying a higher dividend. 

In other words, the price (or more accurately, the intrinsic value) of a share is related to its dividend. 

• That is, the intrinsic value tends to be a constant multiple (i.e. so many times) of the dividend. 
• "How many times?" - this is a very complex subject which will be looked at later.

Dividend yield prevents investors from being side-tracked by irrelevant events.

The Malaysian/Singaporean stock market can be characterised by the occurrence of events which are of no real benefit to the existing shareholders and yet which excite them greatly. 

This is referring to the large numbers of bonus announcements, rights issues, property injections, take-overs and mergers which have made their appearnace in many years. 

Most of these events are of little, if any, real economic benefit to the existing shareholders of the companies involved.  Despite this, the price of shares of a company involved in an event of this nature tends to rise sharply.  These events are, in the main, irrelevant and some of them may even be damaging. 


According to the dividend yield approach to share valuation, a share can have increased value only if there is a likelihood that its dividend will rise faster than originally expected. 

In what way can events like bonuses, rights, mergers and reorganizations in themselves improve the future dividend picture of a company.  If these events cannot lead to such an increase, the share surely does not deserve a higher valuation. 

Here is an often quoted advice to first time share buyers:

A cow for its milk,
Bees for their honey,
And shares, by golly,
For their dividend.

Dividend provides a "floor" for shares during bear markets

Stock markets of the world, especially the Malaysian/Singaporean market, are not readily predictable.  They can collapse so easily into a "bear pit" with little warning.

If we wish to protect our hard earned capital, we must be defensive in our investment approach.

One of the best defence is to buy shares with reasonable dividend yield (i.e. a yield of between one-third to half of the expected long run deposit interest rate). 

If we buy a share becasue it pays a reasonable dividend, our loss is likely to be small even during periods of sharp market decline. 

For example, we can buy a share which pays 30 cents dividend at $5.00 a share and this gives us a dividend yield of 6%.  If the marekt goes into a sharp decline, the amount this share can fall to is limited by the fact that it pays a 30 cents dividend.  If the price is to fall as low as $3.00, it will be giving a dividend yield of 10% which is an excellent return compared to what one can get from fixed deposit and with the additional opportunity to capital gain thrown in.

Most people can see that at that price, the share is probably a good bargain and it is therefore unlikely to fall lower.  From experience, a dividend yield of 10% seems to be the floor below which most stocks will not drop. 

In sharp contrast, shares which pay low or no dividend at all do not seem to have any bottom and price decline can hit 90% or more.

Dividend provides a link with reality

When the market is truly "hot", few of us can remain rational as we tend to be swept along the general atmosphere of optimism.  

But the dividend yield of a share keeps us in close touch with the real world. 

Anyone who closely watched the dividend yield of a share would have realised that the price level was totally unreal.  A good dividend yield stock presently giving a dividend yield of 0.4% due to rising share price, it would be better to sell the share and invest the proceed in other assets or leave the money in fixed deposit.

In the established stock markets of the world, the dividend yield usually has a steady relationship with fixed deposit and its interest rate. 

It is normal for dividend yield to fluctuate at around one-third to half of the long-term fixed deposit interest rate.  This means that when fixed deposit interest is around 6% per annum, stock should sell at a price to provide a yield of 2% or 3%.

Take a look at the yield provided by local shares during bull markets, the dividend yield is usually so low as to be meaningless. 

Furthermore, one should not forget that some fixed deposits and fixed deposits in National Savings Bank are tax free in Malaysia while dividend has a withholding tax applied at source.

Dividend is a sure thing

All too often, investors and speculators pay too much attention to profit forecast. 

It is amazing that so many of the Malaysian companies have the courage to make profit forecast for many years into the future.  What is even more amazing is that so many of the investors seem to believe these forecasts absolutely. 

It is difficult to make a profit forecast a year ahead, let alone five years or even ten years.  Such profit forecasts can only be regarded as extremely shaky. 

Dividend is real and it is something which the shareholders can put to some use.

Most companies keep dividend at a level which they can afford to pay out irrespective of whether it is a good or a bad year and is hence a great deal more certain than profit forecast.

Why is dividend important?

The most important reason is dividend is the only benefit from which a shareholder can obtain from a company under the normal circumstances. 

Earnings, per se, is hardly of any use to him directly and the assets are only of value if the company is liquidated which is unlikely in a great majority of cases.

Apart from the above reason, dividend is important for the following reasons:

(1)  Dividend is a sure thing. 
(2)  Dividend provides a link with reality.
(3)  Dividend provides a "floor" for shares during bear markets.
(4)  Dividend yield prevents investors from being side-tracked by irrelevant events.


A cow for its milk,
Bees for their honey,
And shares, by golly,
For their dividends.

Recession or not McDonald's increases dividend for the 32nd year

Updated: Friday September 25, 2009 MYT 7:55:44 AM
Recession or not McDonald's increases dividend for the 32nd year


OAK BROOK, Illinois: McDonald's Corp. said Thursday that its board has raised its quarterly dividend 10 percent to 55 cents. It will be paid on Dec. 15 to shareholders of record as of Dec. 1. The increase brings its yearly dividend to $2.20 and its total quarterly dividend payout to about $600 million.

The previous quarterly dividend was 50 cents.

The company said it has raised its dividend every year since paying its first dividend in 1976.

The most recent increase puts the company at the high end of its goal to return between $15 billion to $17 billion in cash to shareholders over a three year period that started at the beginning of 2007, the company said.

McDonald's also said it would delist its stock from the Chicago Stock Exchange, where it had its secondary listing.

It decided to leave the Chicago exchange because of low trading volume there.

After Oct. 30, it will be listed only on the New York Stock Exchange.

McDonald's shares rose 58 cents to close Thursday at $56.12.

The stock added another 3 cents after hours following the dividend increase. - AP

http://biz.thestar.com.my/news/story.asp?file=/2009/9/25/business/20090925075349&sec=business


Comment:  

At the price per share of $56.12, the yearly dividend of $2.20 translates into a DY of 3.9%.  This is equivalent to a dividend multiple of 25.5x.

A company giving increasing dividends year on year will see its share price trending upwards in unison.

Given the low interest rates for fixed deposits and low treasury yield, investing into this stock provides a better return comparatively.  Those with a long term investing horizon need not worry about the price volatility of the share.  The long term gains from dividends and capital gains seem safe and predictable as long as the company continues to perform as it did in the past.

Which shares for income?

Which shares for income?
The yield on BT of 19pc sounds good, but remember the adage "if it looks too good to be true, it probably is.

By Gavin Oldham
Published: 3:32PM BST 09 Apr 2009

With the equity market close to a six-year low and with equity yields at historically high levels compared with gilts, the temptation is there for investors to switch into shares: not only in the hunt for income but also factoring in that one day the equity market will recover.

The challenge is, however, to find those rewards without shouldering too much risk; because whereas cash savings can face risk of default, it is in equities that you face investment risk.


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However, it is also worth remembering that since 1900 high-yielding shares have outperformed the stock market as a whole, 85pc of the time over 10-year periods. They've also outperformed the market since September 2008, when the markets really went into freefall.

As an example of the relationship between risk and yield, let's compare two blue chips with apparent dividend attractions: BP and BT.

This week, the yield on BT is 19pc net of basic-rate tax. Sounds good, but remember the adage "if it looks too good to be true, it probably is". Every analyst in the City expects BT to cut its dividend next time around. Investors should be cautious of above-average share yields: the market is telling you "the higher the yield the higher the risk".

BP has a yield of 9pc. Recently, there has been speculation that the low oil price may force the company to cut the dividend. This has proved unfounded, as BP's management has said the dividend will be maintained this year and it will try to maintain it into 2010, even if the oil price stays at current levels. So here we have some medium-term visibility and potential for capital growth if the oil price rises over the medium term.

When considering an investment for yield, note the dividend cover; this is how many times the profits cover the dividend and is an indicator of whether a company will be able to pay future dividends at the current rate or higher. It is calculated by dividing the net earnings per share by the net dividend per share.

Dividend cover = EPS / DPS

or

Dividend cover = 1 / DPO

For example, if a company has earnings per share of 5p and it pays out a dividend of 2.5p, the dividend cover will be 5/2.5 = 2. The higher the cover, the better the chance of maintaining the dividend if profits fall. However, a lower figure may be acceptable if the group's profits are relatively stable.

So a good portfolio of equity income shares would feature mainstream companies with good dividend cover and a relatively recession-proof business (such as energy), plus a good helping of the FTSE 100 iShare – a form of exchange traded fund (ETF) marketed by Barclays – to provide some extra diversification, and to provide the opportunity to take advantage of market volatility.

Such a portfolio might include BP, yielding 9pc with 2.6 times dividend cover; GlaxoSmithKline, yielding 5.5pc with 1.6 times cover; National Grid, yielding 6.5pc with 2 times cover; Scottish & Southern, yielding 5.7pc (1.7); Shell, yielding 4.2pc (3.5); Vodafone, yielding 6pc (1.8) plus the FTSE iShare yielding 5.1pc with no cover calculation available.

An investment of £12,000 could therefore give you about £710 income over a full year, an overall yield of 5.9pc.

These equity shares could provide a relatively stable source of income combined with the potential for capital growth. There is, of course, a risk of further setbacks in the markets that could take your investment value lower, but with blue-chip companies like these it's a relatively low-risk portfolio as equities go.

Keep in touch with the companies you've invested in: if you hold the shares in an Isa or a broker's nominee, opt in for shareholder communications direct from the company. It's your right to be kept informed and it shouldn't cost you extra.

Your holding in the FTSE 100 iShare may provide the opportunity to do some tactical purchases or sales. Rather than buying the whole holding at once, you could invest in £1,000 steps as the market falls back, then set a limit at, say, 10pc up on your purchase price to sell as the market strengthens.

This way you can take advantage of short-term volatility to improve the return on the portfolio as a whole. Finally, if you're a taxpayer make sure you use your Isa allowance to minimise your income tax bill.

Gavin Oldham is chief executive of the Share Centre


http://www.telegraph.co.uk/finance/personalfinance/investing/5131421/Which-shares-for-income.html

Does the value of stocks depend on dividends or earnings?

Does the value of stocks depend on dividends or earnings?

Management determines its dividend policy by evaluating many factors, including:

• the tax differences between dividend income and capital gains,
• the need to generate internal funds to retire debt or invest, and,
• the desire to keep dividends relatively constant in the face of fluctuating earnings.

Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.

However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.

Dividend Payout Ratio

Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments.

The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.

Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.

How to value Stocks?

Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings.

Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)

John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote:

"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."


Ref: Stock for the Long Run, by Jeremy Siegel

Sources of Shareholder Value

Sources of Shareholder Value

For the equity holder, the source of future cash flows is the earnings of firms.

Earnings create value for shareholders by the :

• Payment of cash dividends
• Repurchase of shares
• Retirement of debt
• Investment in securities, capital projects, or other firms.

If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.

If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.

Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.

Which creates more value?

Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.

Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.

Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.

Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.

-----

Fear of misusing retained earnings

If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.

Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.

Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.

In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.

Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.

Ref: Stocks for the Long Run, Jeremy Siegel