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Subject:  Re: FKA: GSK Date:  2/13/2008  2:45 PM
Author:  mungofitch Number:  7397 of 16864

A stock's dividend is a key factor in my choice. If the dividend is above what I could earn from a CD, I am not bothered by stock price movements, as long as the company's business remains stable enough to maintain the dividend.

A good rule of thumb is to buy stocks which are priced at levels
below their intrinsic value (IV). Sure, IV is hard to estimate, being
based on an imperfectly known present and a wildly uncertain future.
But, it's the only method which guarantees good long term results,
so doing it badly is much better than not doing it.

So, your comment is a succinct statement of a very dangerous fallacy.
It's a shame that it is so widely held. In short, only the present and
future earnings and assets matter in determining the value of a firm.
Why so? Dividends aren't income, they are solely a method of
shifting real income payments from one period to another. Raising the
dividend increases the short term at the expense of the long
term---the terminal value of the investment from its assets.
This time shift does not affect the intrinsic value one way or another,
so, at any given level of trend income, a change in the dividend yield
does not change the intrinsic value of the investment.
Real income comes from the underlying business, and its sustainability
and size are solely a function of the (trend) earnings thereof, not
from the timing and method that those earnings flow to the investors.

This isn't to say that dividends aren't rational. A firm should
reinvest only that portion of its trend earnings that it can invest
in such a way as to earn "excess" returns beyond the cost of capital.
The rest should be paid out as dividends. For most firms this means
the most rational choice is to pay out either all of the trend earnings,
or none. Sadly, few companies have management that insightful,
and for most firms dividends are a show of bravado, to keep the
investors on board, the price high, and the options in the money.

One might reasonably argue that increasing dividends is also a slight
predictor of management confidence (though they may be bluffing).
Management confidence may correlate with slightly rosier future, and
since management knows the firm better than anyone, there is a weak
case to be made that rising dividends may correlate with slightly
higher intrinsic value. But it is more like getting a memo that
says things are getting better. It might be true, and might not be.
In and of itself, the dividend itself has not changed the value.

Further, given the choice between two stocks currently priced in the
market at similar discounts to intrinsic value, one might rationally
have a preference for dividend-paying stock versus a non-dividend-paying
stock because of one's personal tax situation.

But, these are all pretty trivial issues, since one normally does best
simply buying the best business at the best discount to its value
after factoring in the range of uncertainties in the estimate.
If the selected investment doesn't pay the income stream you want (it will
always be too little or too much), buy or sell some stock from time to time.

A dividend can be well covered by earnings, not covered, a token, or total fiction.
But if/when a dividend gets cut due to bad operational results, you'll
get hit doubly: once because you get a cut in the dividend that you
have relied on so much, and once because everyone else who falls for
the dividend fallacy bails out at the same time, driving down the
price and wiping out a chunk of your capital as well. This pitfall
won't hit those who have kept their eye on the intrinsic value (which
flows from present and future earnings) rather than the yield.

I'm not saying this particular company isn't a good one, and it may
be both reasonably priced and profitable enough to maintain and raise
its dividend for many years to come. But the level of dividend they
decide on has absolutely no bearing on the intrinsic value, so you
should be aware that you are investing based on a spurious metric,
no more meaningful than the day of the week that the dividend is paid.
Assuming you apply a rational discount rate, changing the timing of
your earnings doesn't change the value a bit.

Just a thought!

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