No. of Recommendations: 7
John, you're certainly on-topic with your inquiry regarding dividends vs retained earnings. Graham and Dodd's book is worth your study; the type of question you have posed and many others like it are the sort of material they cover. They do a much better job than we can at this discussion board. I'll tell you what I've gathered on the subject, though I am unschooled, not an accountant and not a security analyst, so may have a misunderstanding of several points.

First: Retained earnings and shareholder equity are not the same, though I often use the two phrases sloppily without making a distinction. Retained earnings, roughly, is the sum of net earnings, less payment of dividends, over the years since the company was established, and is an accumulation of the profit and loss statements. Shareholder equity (book value) is the difference between total assets and total liabilities, and is a balance sheet number.

If a company had a simple structure, operated in only one currency, never issued additional shares or bought shares back, never acquired other firms or sold off divisions, never wrote off mistakes, and had no unrealized investment gains or losses from stock or bond holdings, then retained earnings plus initial share capital would equal shareholder equity. Most actual companies large enough to be traded on a stock market are not so simple.

Retained earnings are still earnings (if accounting is honest) even though kept in the company to grow the business. If you believe the company is a good one (and you presumably do since you've invested in it), and if you believe the management to be prudent and effective in using funds you entrust to them, then why not have the retained earnings working for you in that business instead of having them paid out, taxed, and then face the difficulty of selecting a suitable place to reinvest them.

The difficulty is that a "security" is often not secure. Managements are not always prudent or effective and sometimes they are discovered, too late, to have been untrustworthy. It is good to have management in the habit of paying some earnings out to the business owners, lest they forget on whose behalf they have been given their jobs.

Graham and Dodd discuss this matter in a related form, when they talk about bonds which require the company to redeem part of the issue annually (sinking fund). That helps prevent the development of bad business habits which can lead to waste of capital.

Dividends should in some sense be viewed as a delivery to the shareholders of part of their equity, which may or may not be from retained earnings. For example, a company with large shareholdings and unrealized gains (never having sold the shares) might distribute the shares of an investee to shareholders as a dividend. Each shareholder would have the same personal net worth (in a value sense) as before the dividend, the only change being that it would then be each shareholder's responsibility to decide whether or not to sell those investee shares. That is the flip side of a shareholder receiving a cash dividend which must then be invested someway.

Sears Canada is an example of a company whose common shares I think should be valued, for investment purposes, only based upon their dividend stream.

I am using data for the 1986-1998 period. The company has recently experienced some changes which might alter my valuation; I have not done any work towards that, preferring to wait and see how well the restructured business operates.

Here are a few figures:

Annual dividends have been constant at 0.24/share since 1986 (earliest info I have).

EPS and book value/share in each year as follows:

1986 ... 0.90 and 8.45
1987 ... 1.22 and 9.43
1988 ... 1.38 and 10.27
1989 ... 1.23 and 11.26
1990 ... 0.25 and 11.25
1991 ... (0.34) and 10.67
1992 ... (1.04) and 9.10
1993 ... 0.05 and 8.90
1994 ... 0.47 and 9.13
1995 ... 0.13 and 9.02
1996 ... 0.09 and 8.98
1997 ... 1.10 and 9.84
1998 ... 1.38 and 10.98
1999 ... 1.88 and ???

Effective the end of Dec/1999 Sears Canada acquired the most desirable locations and assets of a competitor (Eatons) who went out of business, and I have not taken a look at the balance sheet to see whether or how that is represented.

On a peak-to-peak basis, consider the ten years 1989-1998. Starting equity/share was 10.27, ending 10.98, for total equity growth of 0.71 or 0.07/year. Total earnings for those ten years were 3.32, less 2.40 paid out in dividends, for total retained earnings of 0.92 or 0.09/year. The discrepancy is not out of line considering changes in share counts.

Over the same 10 years 1989-1998, Sears Canada grew its number of stores from 100 to 141 (excluding dealer stores and catalogue selling locations), its total shareholders' equity from 883M to 1164M, and its sales from 4621M to 4967M. Not a lot of change in sales. More equity corresponds to the growth in number of stores, but the equity/share did not change much so the ownership of those stores and the company's equity is diluted among more shareholders.

Valuation of Sears Canada shares:

The dividend stream of 0.24/year is steady, even during a severe loss period, so may in effect be valued as if it were interest on a corporate bond coupon, say at 7.0-7.2 pct. The dividends are not guaranteed as bond interest would be, so this is likely on the upside. Because of a feature in Canadian tax laws that gives a tax credit for dividend income, dividend income should be multiplied by about 1.35 to determine the equivalent bond interest income, so the dividend stream is worth about 0.24/0.071*1.35 = 4.50.

Incidentally you see here that 10x earnings is not a "fits all sizes" valuation formula. The earnings over those 10 years averaged .332/year and that would have led to a valuation of only 3.32 not 4.50. I am giving the dividends a bond-like valuation, because those earnings are actually being paid out, and also using a markup because of their tax treatment.

The value of the retained earnings stream as a long term buy and hold investment is in my opinion dubious, since the company did not exhibit the ability to control losses during the prior 1991-1992 business downturn. The Eaton acquisition is a complicating factor, and it is too soon to tell how well Sears Canada will do at turning the Eaton operations into moneymakers. My belief is that the only reasonable investment valuation of Sears Canada retained earnings is Nil.

Any further valuation assigned to the common would be speculative I believe, though it might be a successful speculation if one understood the department store business well and was prepared to trade in and out based upon the valuations of other investors with a short term valuation horizon. For example in 1996 the shares traded in 5.50-6.63 range whereas book value was about 9.00; presumably the dividend history and maybe the book value provided some psychological price support. A purchase in that range would not provide an investment margin of safety but it might be worth the risk as a speculation.

As well there might be a possibility of successful speculation in the stock price only, operating above reasonable valuation of the shares for investment and speculation, if one is lucky or has a good feel for brokerage house and market pricing dynamics. For example the shares traded in 1998 in the 19.00-25.75 range. I know of one "value" fund which holds the shares with a cost basis in the 30s.

But, considered as a possible buy and hold investment, the dividends are all the value I can identify.

That ambiguous valuation illustrates the distinction between investment and speculation. Graham and Dodd devote quite a bit of effort to exploring that topic. Their advice is not to attempt to mix, and it is sound but I am nonetheless tempted!

One key point that I get from their writing is to know why you are buying shares in a company; for investment or for speculation. As well, if speculating, I think it may be advisable to have a clear understanding about what exactly is the speculation so that there are trigger events that get one out when everything still looks rosy.


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