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Author: ZenvestorB Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1933  
Subject: Chapter 29 Date: 12/23/2000 4:50 PM
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Hi Everybody,

Here's a take on a summary of Chapter 29, The Dividend Factor in Common Stock Analysis.

The natural classification of the elements entering into the valuation of a common stock would be under three headings:

1. The dividend rate and record.
2. Income Account factors. (earnings power)
3. Balance Sheet factors. (asset value)

The exact significance of the dividend rate is exceedingly difficult to appraise. From one point of view, the dividend rate is all important; but from another and equally valid standpoint it must be considered an accidental and minor factor.

Until recent years (referring to the publish date), the dividend return was the overshadowing factor in common-stock investment. The view was that the prime purpose of a business was to pay dividends to its owners. Since the idea of investment was closely bound up with that of dependable income, it follows that investment in common stocks would be confined to those with a well established dividend and that the price paid for a common stock would be determined chiefly by the amount of the dividend.

This investor aimed primarily for a steady income return, which in general would be both somewhat larger and somewhat less certain than that provided by good senior securities.

On the other hand, there are equally authoritative and well established principles of corporate management which subordinates the current dividend for the future welfare of the corporation and its shareholders.

When management withholds and reinvests profits, thus building up an accumulated surplus, it claims confidently to be acting for the best interests of the shareholders. The rank and file of stockholders will give such policies their support, either because they are individually convinced that this procedure rebounds to their advantage or because they accept uncritically the authority of the management's and bankers who recommend it.

But this shareholder approval seems to have an element of reluctance. The typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself. No instances are on record in which the withholding of dividends for the sake of future profits has been hailed with such enthusiasm as to advance the price of the stock. The direct opposite has invariably been true. Given two companies in the same general position and with the same earning power, the one paying the larger dividend will always sell at the higher price.

Examining the policy of withholding dividends, we see that it rests upon two quite distinct assumptions.

1. It is advantageous to the stockholders to leave a substantial part of the annual earnings in the business.
2. It is desirable to maintain a steady dividend rate in the face of fluctuations in profits.

As to the 2nd point, there would be no question at all, provided the dividend stability is achieved without too great a sacrifice in the amount of the dividend. But in practice this is rarely followed. It's found that the stability of dividends is usually accomplished by the simple expedient of paying out a small part of the average earnings. The question arises, very properly, whether the shareholders might not prefer a much larger aggregate dividend, even with some irregularity.

There may be some truth in that it is advantageous to the stockholders if a large portion of the annual earnings are retained in the business. The customary reasoning on this point are as follows:

Major Premise: Whatever benefits the company benefits the stockholders.

Minor Premise: A company is benefited if its earnings are retained rather than paid in dividends.

Conclusion: Stockholders are benefited by the withholding of corporate earnings.

The weakness of the above reasoning rests in the major premise. Whatever benefits a business benefits its owners provided the benefit is not conferred upon the corporation at the expense of the stockholders.

One of the obstacles in the way of an intelligent understanding by stockholders of the dividend question is the accepted notion that the determination of dividend policies is entirely a management function, in the same way as the general running of the business. But if stockholders opinion were properly informed, it would insist upon curtailing the despotic powers given the directorate over the dividend policy. Experience shows that these unrestricted powers are likely to be abused, and for various reasons. Boards of Directors usually consist of largely of executive officers and their friends. The officers are naturally desirous of retaining as much cash as possible in the treasury, in order to satisfy their financial problems. They are also inclined to expand the business persistently for the sake of personal aggrandizement and to secure higher salaries.

Viewing American corporate dividend policies as a whole, it cannot be said that the virtually unlimited power given the management on this score has redounded to the benefit of the stockholders. Dividend policies are often so arbitrarily managed as to introduce an additional uncertainty in the analysis of a common stock. Besides the difficulty of judging the earnings power, there is the second difficulty of predicting what part of the earnings the directors will see fit to disburse in dividends.

From this chapter, certain conclusions may be drawn.

Experience will confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus. The common stock investor should ordinarily require both an adequate earning power and an adequate dividend. If the dividend is disproportionately small, an investment purchase will be justified only on an exceptionally impressive showing of earnings or by a very special situation with respect to liquid assets.

(An especially interesting section that shows the development of these ideas on more of a quantitative basis is located on the bottom of page 333 and continues on page 334.)

The dividend rate is seen to be important, apart from the earnings, not only because the investor naturally wants cash income from his capital but also because the earnings which are not paid out in dividends have a tendency to lose part of their effective value for the stockholder.

While it is concluded that the payment of a liberal portion of the earnings in dividends adds definitively to the attractiveness of a common stock, it must be recognized that this conclusion involves a curious paradox. Value is increased by taking away value.


(I thought it was a pretty interesting look at an often ignored topic. Happy Holidays to all !)

ZB
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