A thought experiment

Let’s assume as an investor you had a choice between investing in two companies. A and B are identical companies operating in a duopoly with equal market share. Every year, each of them generates $100 in profit. While company A decides to re-invest $50 in the business and pay $50 in dividends, company B pays all $100 in dividends. The question is, which company would be more valuable in the market?

 

All else equal, from a P/E perspective, both companies should trade similarly. One can make the argument that company B would have a higher dividend yield and eventually investors will bid company B’s price higher. What happens if we introduce the fourth investing dimension, time.

 

As investors, our decisions are based on future cash flows, not past ones. One year from now, a higher dividend payout ratio won’t make a difference, but in 5-10 years it might. In year 5, company A will have invested $250 in the business increasing the value of its product/service and/or growing faster than company B. Now we ask the same question again, which company would be more valuable in the market? Company A.

 

The counter-argument is of course, investors of company B will have received dividends in the meantime. Yes, that is true, but if company A is investing at a higher rate of return than their cost of capital, they are creating significantly more value. Dollars reinvested in the business are usually worth more than dollars in dividends due to lesser taxation and the compounding effect.

 

A tale of two companies

Let’s look at two companies in Canada to see if our thought experiment is consistent with the real world. Rogers and Bell are the closest thing to two Canadian companies operating in similar lines of businesses. Over the past 5 years:

• Rogers spent +60% of their cash flow from operations on capex while Bell ~50%
• Bell spent almost all of its earnings on dividends with a payout ratio of 87% in 2019, while Rogers is more conservative at 50%
• In order to maintain its capex and dividend needs, Bell has increased its long-term debt by 7% annualized while Rogers only 3%. Debt is a future cost, which shareholders will bear.

How would the market reward these two companies?

Rogers while spending more on the business, paying less dividends out of earnings and taking on less debt has outperformed Bell by 2% a year for 5 years. While Bell returned a reasonable ~14% annualized (including dividends), our conclusion is that paying more dividends is not always a good idea.

 

Where does that leave us?

We are strong advocates of a company reinvesting their cash flow in the business. Unless a business has exhausted all other areas of reinvestment, then a business should pay its shareholders in dividends, or share buybacks in case the stock price is undervalued. However, under no circumstance do we agree that a company maintains an elevated payout ratio.

 

What about bear markets?

In a bull market, some investors mistakenly prefer the higher payout stock. In a bear market, that usually means the economy is in a recession, the opposite happens. A recession means revenue pressure, and the company that was paying out most of its cash flow, and underinvesting in its business now has the problem that the dividend is in excess of cash flow, often producing a dividend cut. There is nothing that sends a stock down faster than a dividend cut.