As I continue to read (and fall in love with) The Essays of Warren Buffett I can’t help but urge you to buy this book on your own. I love giving these short chapter summaries, and today I’m going to focus on Dividend Policy, but I think it’s well worth the ~$30 to buy it on Amazon…but what do I know?
If you have listened to Buffett before, you know that he really places a strong emphasis on a company’s dividend performance. This chapter was particularly interesting because he really focused on two different situations, paying dividends and shares repurchases, and as to the correct timing and situation where a company should consider either.
Paying out Dividends
While Buffett loves for a company to pay a dividend, he really keys in on the importance of a company not paying a dividend simply just to do so.
Nowadays, I feel like a lot of pressure is put on a company to pay a dividend, so you might see a company implement a dividend, and then have pressure to continuously increase that dividend, even though it might be making them cash poor and causing them to miss out on future opportunities for M&A or to put some extra lighter fluid on the business and make the flame grow harder and stronger.
Buffett says that when a company is reviewing whether to distribute the their retained earnings via a dividend or to hold onto it for future opportunities, the company should have the following mindset: “For every dollar of retained earnings by the corporation, at least one dollar of market value will be created for owners.”
I think it’s important to note here that Buffett is looking for a dollar of future earnings/market value at some point in the future – not an immediate increase. The company shouldn’t choose each quarter to pay a dividend or to buy a company – they need to take the time to continue to be strategic with their decision-making.
An example that Buffett gives is to imagine if you had invested $10,000 in bonds that were returning 10% every year. So, after the first year, you now have $11,000. You have the option to either take that money in cash or to reinvest it back into the same bond.
If your alternative is to take the cash and put it somewhere where you made 5%, would you keep it in the 10% bond or take it out?
What if your alternative was to take it out and make 15%? Would you then keep it in the 10% bond or take out to make 15%?
These both should be super easy to answer – always choose to make more interest, regardless of what that might mean. This is no different for a company paying dividends. If they can provide an extra dollar of earnings through a dividend to an investor, this should increase their value as a company accordingly as the value is increased to the shareholder.
For the company to decided to not pay out that $1 in dividends, they should make sure that they’re able to use that $1 of earnings to generate a future value of something that is $1, at a minimum, or likely much more.
When a company buys back shares, they should be able to significantly increase the value of the company by buying these shares back. Not only is the company buying back ‘cheap’ shares which should drive the value of the company to a higher price, but if there are less shares on the market, then the EPS should increase, even if net earnings stay the same, simply because there are now less shares on the open market.
When a company chooses to repurchase shares, it shows that the management is truly focused on shareholder value. It is very important, however, that a company only buys back shares if they have sufficient cash and the stock is undervalued.
Buffett states that shares are often times repurchased to show confidence in the company. CEO’s are too optimistic about their own company and it causes them to buy back shares at a price that is actually a fair valuation for the company rather than the company being undervalued like the CEO might think.
While a CEO should, and likely does, know more about the business than anyone else, it is also very easy for the CEO to have blinders on and be somewhat to what the actual fair price is for their company.
Buffett goes on to talk about how some companies will buy back shares to show to the market that they think their stock is undervalued, and this will theoretically make the market think the company is undervalued as well, and potentially stop (and correct) the decline in price that the company has been experiencing.
Buffett thinks this is just plain wrong:
“We will never make purchases with the intention of stemming a decline in Berkshire’s price. Rather we will make them if and when we believe that they represent an attractive use of the Company’s money.”
I’ll be honest – I completely agree with him. This is stock price manipulation. It might not be intentional, but it could create a sharp rebound from the price declines before the stock truly ever does become undervalued.
As a shareholder, this is not a good thing for you because not only is it limiting your ability to buy back in at a “clearance” price, but also your own company (since you are a part owner) is overpaying for these shares, therefore you’re investing in a company that isn’t utilizing their money in the best way possible.
In summary, a company should really only withhold a dividend payment to meet one of these two situations:
- The company needs to maintain this money to continue current operations and to maintain a strong financial position
- The company can generate an amount of future value that is greater than the amount of earnings that they were withholding
And if a company is going to repurchase shares, you want to make sure of the following:
- The company has the capital to purchase these shares back without running into any future issues or having to turn down great future M&A opportunities
- The company’s stock price is greatly undervalued, and this is going to be able to spark value to their shareholders
If a company is going to hold onto earnings or repurchase shares and this criteria is not met, it could be a red flag. Not a sign to drop what you’re doing, log onto your broker account and sell immediately – but simply something to keep an eye on for the future.
I’ll finish it off with maybe my favorite Buffett Quote ever…
“If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.” Mic Drop.