The lure of companies paying high dividends is huge. For example Nordea Bank AB paid a week ago over 7 % dividend yield on its stock. Usually especially European value stocks have been paying generously high yields of dividends to the investors. Investors get the dividends (with a few tax exemptions in some countries) and can re-invest these dividends back to the stock market to gain the compound interest, which could boost the investors wealth considerable in the long run. It could be considered as investing "free money" to gain even more "free money" the year after.
Compound interest is the reason why I have been investing in value stocks which have a high dividend yield and great potential to increase it. But from what I have heard from analysts, professors and bankers, they all despise dividends and hate corporations that do that. That got me investigating the matter a bit more.
Let's consider a value firm which pays a good dividend for the stock. Now, the company is giving money outside to the company to the shareholders, which means that the cash isn't there for future investments. Shareholders are happy, but analysts and bankers are not.
Investing in assets is important when we consider the growth of the corporation. Capital expenditure and the increase in the long-term assets tell that something is going on in the company: They are investing in their operations. This means that something is coming and it will have a positive or a negative effect to the company.
For sure if the managers are wise, they pay the dividends so that there exists cash to do the planned investments. But still, less funds are available to invest in growth of shareholder equity.
In the worst case scenario, the free cash flow after paying the dividends can be negative! This isn't not so uncommon from what I've discovered. For example Finnish company Sampo generated free cash flow of 1,255bn€ and paid dividends worth of 1,286bn€ in 2017, creating a small deficit. In 2016 the situation was more severe: Sampo's free cash flow was 182m€ and paid dividends worth of 1,2bn€, creating a deficit of 1bn€
So who finances this deficit? Who pays these dividends? The banks of course!
Let's break it down a bit: After you've generated the cash, what do you have to pay with that? You have to pay your capital expenditure for compulsory investments and have the sufficient working capital for your business to operate. After that, whatever becomes negative, is financed from long-term liabilities. Paying dividends financed by debt sounds rather unorthodox and from this you get an evil eye from the bankers who are considering to grant a loan for the corporation.
What about the assets? What is the effect for the corporation that pays dividends but doesn't invest? Especially from bankers' and analysts' perspective we are interested on what the corporation does with its liabilities. If debt is used for gearing some investments and long-term acquisitions, woah that's good. And you get tax exemptions as well. But if the liabilities are used to finance dividends, firm isn't necessarily growing since it isn't investing in new businesses.
The money you get is away from the corporation and from the growth.
If we think in depth how a balance sheet works, it should be that long-term liabilities finance long-term assets and current liabilities finance current assets. If long-term finances short-term and short term finances long-term, it also sounds a bit wrong. This is why also cash should be financed from current liabilities and not from a bank loan.
What I've learned is to be more critical towards generous payout ratios of dividends and focus more on the free cash flow in a corporation when taking it into evaluation.
Berkshire Hathaway hasn't paid dividend in 50 years. When the question of whether the company should pay dividends or not was popped up in the annual shareholder meeting, the shareholders said: "Just don't. Keep investing the money as the same way you have done before, you are going to do it better than us".
In the 1990's dividend stocks weren't that much of a hot topic. Could it be that the modern society of "everything to me as soon as possible" has gotten us to praise dividends without that much consideration?
Text: SW
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