What is a dividend?
A dividend is a cash distribution made by a company on a regular or one time basis. It is at management’s discretion whether they pay a dividend or not. There are companies that have had regular dividends for years. Typically they are mature businesses that are no longer in their growth stages, and use a portion of their excess cash to distribute to their shareholders.
There is a popular investment strategy that focuses on buying companies that regularly pay dividends. Such an income strategy is usually adopted by people that have a large asset base and would like to receive regular cash distributions. If you don’t need the cash from the distribution you should automatically reinvest any dividends you get in order to get the compounding effect of increasing your share holdings and having those new shares generate future dividend distributions.
As a value investor the real question is how should you think about dividends, and would they affect your valuations. A dividend is usually taken from excess revenue that the company earns. That effectively means that it will reduce the amount of free cash flow available. When the company pays a dividend it also means that it is foregoing the opportunity to reinvest its excess cash back into the business in order to pay shareholders.
There is an argument to be made that the best payoff for shareholders would be to continue to grow the company instead of distributing the cash. With that point of view a dividend payout benefits the short term shareholder that wants to get an immediate return. If you consider your holding period to be forever then you would probably prefer that the business use that cash to continue to invest in itself. But just because a company pays a dividend doesn’t mean that you should automatically disqualify it from your consideration as a good value investment.
How to Use Information About Dividends When Evaluating a Company
The first thing you should consider is how the company is funding it’s dividend. If the the dividend is a result of an abundance of sales and revenue and the company is fully maximizing it’s research and has a strong operating discipline, then that should be considered safe way to fund its dividend. This will be taking away some of it’s cash available for growing the business, but it generally should not be putting the company at risk.
If a dividend is paid from taking out debt you may want to dig a bit deeper into whether this is a bonus or a risk. It’s possible that the company may want to take advantage of low borrowing costs so they take on debt to cover the cost of the dividend and use their cash on hand to continue to grow the company. Apple, for instance, has over $200 Billion of cash in it’s balance sheet, however since much of that cash is being held overseas and would incur a high tax burden if it was repatriated and brought onshore, it has chosen to take on debt to finance both it’s dividend and stock repurchase plan. In such circumstances that may be ok, but if a company does not have excess cash and they are taking on debt to finance a dividend that should be a red flag and you should get to the bottom of why management is using accounting tricks to pay shareholders.
If a company has a regular dividend that it has been paying out consistently for 5 or more years, that usually indicates that the company is stable and is operating somewhat efficiently. Your valuation calculations should not be impacted by the company’s habits of paying dividends since the free cash flow available can be calculated with line items reported in a different section of the cashflow statement. Yahoo! Finance displays the amount distributed as Dividends Paid in their cashflow statements page. The following screen capture shows Oracle’s (ORCL) cashflow statement with highlighted dividends:
If a company is paying a one-time dividend, find out why it is doing that. Sometimes a company may divest from a business venture and distribute the cash to shareholders. That scenario is typically not a risky one unless the company is getting rid of a core part of the business at which point you should reassess whether you still want to own that stock. If the reason for the irregular dividend is due to other factors such as an activist investor demanding a dividend, it’s also time to evaluate the riskiness of such a stock, and management’s competence and vision for the future of the company. If management is willing to please short-term investors in this way that is not a good sign that the stock is a good long-term investment.
If you are a shareholder of a company that pays dividends you should have those dividends automatically reinvested.