Is dividend really helping your wealth creation?
- Rupam Deb
- Jun 17, 2019
- 11 min read
They say ‘a picture is worth a thousand words’… extending that, a video must be ‘worth a million words’.
So I have made your life easy by creating a video (instead of writing a long post) to run you through this experiment which I carried out to see if receiving a dividend is really the best option for shareholders is all scenarios. It turns out that it is not… Watch the video to see what I mean
Scenario 1:
Calculations of resultant equity when a dividend is paid out
Scenario 2:
Calculations of resultant equity when a dividend is NOT paid… and the cashflow is generating by selling along some shares (P/B >1)
Scenario 3:
Calculations of resultant equity when a dividend is NOT paid… and the cashflow is generating by selling along some shares (P/B <1)
In case you are the kind who prefers “reading than watching a video”, we have transcribed the entire video just for you.
So today we are going to do an experiment, we were to use these poker chips to highlight a concept, which I actually learned from one of Buffett’s letters to the shareholders of 2012. Now, as investors, we all like our fat juicy dividend, we like to own a portfolio of companies. And we feel very happy when the company pays out its dividends. So what we are going to do is we’re going to do an experiment. And we have assigned a value for each of these chips. The black ones are $100,000. $25,000 for the green ones. $10,000, for blue. $5,000, for red. and $1,000, for the white, this is our company, we are going to use the left side of the box, which starts with a million dollars of equity. Now, let’s assume for the time being that I’m one of the owners of the business. And let’s assume that this is my share of the equity in the business. So this is not the entire business, but this is my share of the equity. So the experiment is going to be based on my share of the equity. Now let’s assume this business is a well-run business generating a consistent return on equity of 20%. And the business has a payout ratio of 30%, which means 30% of the net earnings every year is distributed as dividends. So this is your zero where my share of the equity is a million dollars, which is 10 black chips. in year one, the business generates total earnings of $200,000, which is my share of the total earnings. Now out of that $200,000 $60,000 gets deposited in my dividend box, which is this box, and $140,000, gets added to the equity side as retained earnings. in year two, the same thing happens, the business generates a 20% return on equity. So my share of the total earnings is $220,000, out of which $68,000 gets paid out to me as a dividend. And $160,000 is retained earnings, which gets added to the equity side. So after two years of operations, my cumulative dividend is $120,000. And the total equity, which is my share of the book value is $1.3 billion. Now I’m going to make all these calculations available in a sheet so that it’s very easy for everybody to follow. Now, let’s look at a different scenario, where we assume that the business does not pay any dividend it continues to generate a return on equity of 20%, but it does not pay any dividend. So as an owner of the business, I need cash flows, right? I need cash flows to pay my expenses. So where does that cash flow come from? So I decide to sell some shares every year to generate the same amount of cash flow which I was generating earlier, from my dividends. Now, this is obviously a listed company. And let’s assume the equities trading in the stock markets at a price to book ratio of two times, which means every $1,000 worth of equity. That is the book value is trading in the markets for $2,000. So this scenario, also, the business starts with starting equity, which is my share of the equity of a million dollars, and it consistently generates a return on equity of 20%. So after the first year, the business generates 200,000 of earnings for me, which is this 200,000. Now, remember, this time the business is not paying out a dividend, but I need my cash flows. So what I’m going to do is I’m going to sell enough number of shares to produce a cash flow of $60,000. For me, because in the first scenario where the company was paying a dividend, in the first year, I had received a dividend of $60,000. So I’m trying to replace that cash. So, what I do is I go to the market, let’s assume this, this green box is the market and I go and sell enough number of shares to generate the $60,000 of cash flow. Now, because the price to book multiple is two times, which means the number of shares that I need to sell the book value of that is $30,000. So, I take $30,000 worth of my equity and I sell it in the market and from the market, I get $60,000 of cash flow, which gets deposited in my cash flow bonds. So in this case, this right-hand side box is my capital bonds. Now, as a result, the remaining amount of equity in the business is $1.17 million
in here to the business again generates 20% return on equity and the total share of earnings that the business generates for me is $234,000. Now again, I need to generate $68,000 of cash flow just like the previous time I got a dividend of $60,000. So what I do is I again go to the market, and I have to sell $30,000 worth of book value. To be able to receive $68,000 at the price to book is still two times. So, this $68,000 is my cash flow. And what I have to do is I have to reduce my share of the equity by $34,000 because this has been sold. So now, as you can see, these two boxes contain exactly the same amount of cash, both of them contain $120,000. In the first case, I received the $120,000 as a dividend and in the second case, I see this $120,000 by selling a certain amount of shares in the market. However, if I look at the equity side, what I realised is, in the second case, I have a higher amount of equity remaining in the business as compared to the first scenario. In the second scenario, where I sold a little bit of my stock to generate this cash flow, my remaining equity is $1.37 million, as compared to $1.3 million in the first place. So, the concept is very simple, because the market value of each share is higher than the book value of the share, I get to generate a certain amount of cash flow by compromising on a lesser amount of book value when I’m setting the ships, whereas when the company is paying a dividend, the entire cash flow is coming from the book value of my share in the business. So, this is what happens when the price to book ratio is greater than one, let’s look at a scenario where the price to book ratio is less than one. So now let’s look at the third scenario, where we start the business with our share of equity as a million dollars. And the price to book ratio is less than one. So let’s assume the price to book ratio is 0.7, five. So which means every $1,000 worth of book value of equity is trading in the markets for $750. Now, after year one, again, our share of equity generates earnings of $200,000. So this $200,000 gets deposited in the equity side as retained earnings. However, I have to generate a cash flow for myself for $60,000. So that cash flow gets generated from the market. So I sell enough shares to pay me $60,000. But as the price to book ratio is point seven, five, I have to sell 80,000 worth of shares to be able to generate $60,000 from the market. So this $60,000 of cash flow gets deposited in my cash flow box, and my share of the equity gets reduced by $80,000. in year two, again, the business generates a return on equity of 20%, which means $224,000 is my share of earnings, which gets deposited on the equity side. But as I have to generate a cash flow of $68,000, similar to the dividend scenario, I generate that $68,000 by selling $91,000 of book value. So this $91,000 get reduced from my share of the book value. And the $68,000 get added to my cash flow box. So now let’s look at the result. So again, just like the dividend scenario, I have generated $128,000 of cash for myself. But my share of the book value is only $1,253,000, which is less than my share of book value in the dividend scenario, which is $1.3 million. So again, the principle gets reinforced here that when the shares are trading in a market at a price, which is higher than the book value of each share, it’s actually advantages for us as a shareholder to sell some shares to generate the cash flow instead of reducing our book value
in the process of getting a dividend, whereas when the price to book ratio is less than one, it makes sense for the business to give out a dividend for us to achieve that cash flow. Now when the price to book ratio is exactly one, it really doesn’t matter. both scenarios will leave exactly the same result, whether I generate $128,000 by selling shares or whether I generate $120,000 by receiving a dividend and thereby reducing my book value, it’s exactly the same. Now, you know when people hear about this concert, certain people have the tendency of countering by saying that over 20% is not a realistic scenario. but whether a company should pay out a dividend or not will depend upon whether it has the ability to reinvest that money and generate the same return on invested capital. But guys, it doesn’t matter. Here we’re comparing between three scenarios. Which are apples to apples, it all the three scenarios assumes the same return on equity. And it all in all the three scenarios assumes that the business has the ability to reinvest the funds in the business to generate the same return on invested capital. So it’s just a mathematical fact, which I’m trying to explain. Now, if the business was unable to reinvest the amount, the reinvest the funds to generate the same return on invested capital, maybe, you know, the market price will suffer. And, you know, maybe the price to book ratio will change. But that’s beside the point. What’s important here is that for everything else remaining constant, whether that dividend is advantages to the shareholders or not, it depends upon the price to book ratio here, if the price to book ratio is less than one, it makes sense for the shareholders to receive the cash in form of a dividend. But if the price to book ratio is greater than one, it does not make sense for the shareholders to dilute their share of the book value in form of a dividend. And I will actually encourage you to do the calculations yourself, you know, take different scenarios take a different return on equity assumptions, take different payout ratio assumptions, take different price to book assumptions and do the calculations and it will be very clear to you. Now, this is something which did not occur to me naturally, I was not born with this wisdom. But when I read Buffett’s letters to shareholders in 2012, it was a great aha moment for me. In fact, you know, a lot of what I have learned about investing, I would like to thank Mr. Warren Buffett for that. So you know, Glenn, read that letter and go and do the calculations yourself. This is a very, very common myth, where people, they just blindly follow on wisdom without really understanding the math behind it. And it will be clear if you do the calculations yourself, so let me explain as a disadvantage the dividends have. Now, let’s assume this is the total cash flow that I have received as a dividend. Now what happens is, of course, different countries have different tax rates, but this entire amount gets taxed as income. So let’s say the tax rate of certain countries 30%. So 30% of this tax gets taken away as a tax, I only get to receive this. Whereas if this cash flow has been generated by selling a certain number of shares, then we need to look at what was the cost price of those shares. And let’s say the cost price of those shares is this. So only the difference between the two is the capital gains, which is taxed as capital gains tax. So this is this becomes the base for the capital gains tax. Now, fortunately, I live in Singapore where there is no capital gains tax, or there is no dividend tax. So I think that’s a huge advantage when it comes to long term compounding. But that’s beside the point, we have to be very, very careful about this particular concept that in the long run, the tax that we are paying on our gains, that makes a huge dent in our long term wealth. So you know, this distinction is exactly the reason why Berkshire doesn’t pay out a dividend. And Buffett, again, explain this very elegantly in his 2012 letter to shareholders, that it completely depends upon an individual shareholder. When it comes to selling shares. Depending upon at what stage of life he’s in, he can decide to sell maybe just a few shares or higher number of shares to achieve his cash flows. Whereas when it comes to dividend, you can’t really separate one shareholder from another. You know, all shareholders get treated uniformly. And fortunately, for some shareholders, it’s not in his best interest to receive the dividend year after year. For example, if we were to be shareholders of Berkshire Hathaway or for that matter, any us listed stock, every time the company pays out a dividend to US foreign shareholders 30% of that would be taken away as a withholding tax. Whereas when we sell shares to achieve the same cash flows, only the capital gains part becomes taxable depending on which country you live in. So these are some of the nuances it’s very important to be aware of. I will also encourage you to go and watch our free six-part video series which I have recently created, you can subscribe with your email id on moneywisesmart.com.
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