Retail Investor .org

UNDERSTANDING CHANGES TO OWNERS' EQUITY

Since the mid 1990's investors' ownership interest in companies has been impacted MORE by changes to the companies' equity than by the companies' earnings. This is not an exaggeration. None of the reporting systems measure or report this effect. They are all geared to report on the company as a whole - not the portion attributable to a stock. Investors must learn how to correctly interpret changes. They must measure for themselves the effects of equity changes.

Rates of Return To Investors
The different uses of profits generate different rates of return for the investor. This should factor into your decision on which is preferable. Issuing additional shares is the same as a negative buyback. Its proceeds increase the $$ reinvested. This table is automated in the Different Yields spreadsheet.

Dividends

1. Dividends paid on common shares are not created out of thin air. They are a transfer of value from the company to the owner. Each dividend dollar creates a dollar capital loss. This is completely different from dividends paid on preferred shares. In that case the dividends ARE income because the principle (face value of the preferred share) has not been affected.
2. Dividend dollars earn the investor a rate of return usually far lower than the return earned by reinvesting in the business. This depends on the incremental ROE, but generally cash inside a business is more productive than cash in the secondary markets.
3. Dividends reflects a lack of better business opportunities, or a preference by management for a certain type of investor.
4. Companies with large DRIPs know the cash for those dividends will never leave the company bank account. With (say) 25 percent of investors in DRIPs, the company can declare a dividend one third higher than it could otherwise afford.
5. When some shareholders DRIP and others take cash dividends, neither class of owners ends up better or worse off than the other. Those that DRIP gain extra shares. Those taking cash have their ownership % diluted.
6. Management compensation that depends on capital appreciation may contain clauses protecting management from large dividend effects. The number of stock options held can be grossed up by the capital lost to the distribution. Similarly, when convertible securities are issued to 'friends of the business' there can be a provision to lower the exercise price because of distributions. The resulting dilution is not captured by any reporting metrics.
7. Dividends can be used to hide management compensation, because dividends are not a deduction before Net Income. Shares are issued to management for debt. Dividends paid on those shares are journal-entry'd to pay down the debt and should be considered management wages. The issue of shares is just an excuse to label the cash 'dividends' instead of 'wages'. The exact same thing could be accomplished by paying wages and requiring the executive to buy shares with it. It is impossible to determine from the financials what the dollar value of this is. While this strategy will always raise reported Net Income in total, it will only raise EPS when the dividends are greater than earnings, so you see this strategy in REITs and Income Trusts with high distributions. See separate page of explaination.
8. Dividends can be used to hide management compensation a second way. When shares are repurchased and not cancelled (or issued without being sold to outsiders), they may be in a trust structure for the benefit of management. That means any dividends received by those shares do not accrue back to the benefit of the company as a whole. They increase the value of the trust - usually spent buying more shares for the trust. This eventually is distributed to management.
9. Dividends can be used to hide interest expense. It is not unusual to see the AVERAGE number of shares outstanding in a period being greater than the number outstanding at both the BEGINNING and END of the period. This may be the result of a delay between the time of issuing new shares on the exercise of stock options and the time of repurchasing them from the market. But this may also indicates the existence of financing with company shares. There may be an agreement with a bank to sell them shares for cash, and a repurchase price agreed at the start. That price includes interest on the cash 'borrowed'. Any dividends issued during the period would reduce interest added to the repurchase price.

Share BuyBacks

1. Share buybacks are equivalent to the payment of dividends. The cash moves from the productive operating sector of the economy to the secondary markets, just like dividends do. If 5% of the outstanding shares are repurchased then the investor has a 5% gain.
2. Unlike dividends, the cash for buybacks goes to people selling their shares, rather than to the continuing owners.
3. Unlike dividends, no taxes on the investor are triggered by share buy-backs.
4. When offset by the issue of additional shares (say, from the exercise of options), there is no benefit to owners. This is ignored in the many reports claiming that buybacks have replaced (historically much higher) dividends.
5. The timing of share buybacks should be opposite from the time chosen to exercise stock options. Options will be exercised when the owner believes the stock price is peaking. Companies should invest in their own shares when the stock price is bottoming ... for the same reason everyone buys shares (buy low - sell high). In practice, companies may buy back shares BECAUSE of options being exercised - at the exact worse time.
6. Shares may be bought-back, but not cancelled, at the time options are granted, at the price equal to the exercise value of the options. This creates the superficial appearance that the options are 'fully funded'. When the option is eventually exercised, those shares in treasury are used, with no change in dollar value recorded, or change to the gross number of shares outstanding, in Shareholders' Equity. In reality this does not change the opportunity cost of options. The two transactions should be measured separately. See the details at Comprehensive Income
7. How investors should interpret treasury shares (showing as negative Shareholder Equity) depends on whether their ownership rests with the company as a whole, or whether they sit in a trust for the benefit of management only. The 'number of shares outstanding' used in the calculation of 'book value per share' and 'earning per share' should be the greater (gross) number when purchased shares are owned by management. Otherwise, the calculations use the reduced (net) number of shares. This also means the calculation of ROE based on 'eps' and 'book value per share' will differ from the metric based on Net Income and Equity. See this example from Legg Mason.
8. Since buybacks are financially equivalent to dividends it is reasonable to conclude that valuation calculations based on the present value of future dividends should include buybacks as quasi-dividends. But it has been argued that this results in double counting, when the analysis is done on a per-share basis. The cash used for the buyback is the first 'count'. But the number of shares outstanding has been reduced as a result, so in future, the same amount of cash (in total) can fund a higher dividend (on a per-share basis). This growth in the dividend is the second 'count'. If you know a more detailed presentation of this argument, please contact this site.

Reinvesting Profits

1. When profits are reinvested in growing the company, the investor will earn a rate of return equal to the ROE of the incremental business. This should be used as the company's expected rate of growth.
2. If retained profits are used to pay down debt, the investor's return will equal the interest rate of the debt.
3. Whether reinvesting profits is better than paying dividends all depends on the use to which the cash is put - the incremental ROE.

DRIP's

1. Dividend Reinvestment Plans recycle the nominal dividend's cash back to the company by paying with script (shares) instead.
2. This is equivalent to reinvesting profits... but inefficient due to costs.
3. DRIPs are not equivalent to the shareholder receiving cash dividends, to be re-deployed in the secondary market. The cash is retained within the business where it is more productive than when in the secondary market .
4. Investors earns a rate of return according to the same criteria as seen above in "Reinvesting Profits".

Share Issues

1. A company's issue of shares and then payment of a dividend with part of the proceeds, is equivalent to an investor selling a portion of their shares in the secondary market. See example below.
2. If additional shares are sold for market value, the investor is indifferent.
3. If sold for less than market value, the investor suffers a loss equal to the discount. That loss will equal the gain to the buyer of the discounted shares - usually employment compensation from exercising stock options. Investors must measure this loss and deduct it from published Net Income and EPS. See the details at Comprehensive Income.
4. Issuing shares does not dilute existing owners because $proceeds are received in exchange. The question is "Will the $proceeds be put to work earning the profits anticipated by the market price of the stock?"
5. If issued at twice book value the $proceeds need only be invested at half the ROE of the pre-existing assets in order for the EPS to remain the same. If issued at 1.5 times book value, the proceeds need only earn a return equal to 2/3 of the pre-existing ROE for the EPS to remain the same. Etc.
6. If sold for less than "book value per share", each resulting share will have fewer assets working for it. EPS will be expected to decline. The company would be in dire straights before doing this. Investors must measure the loss of "book value per share" and make their own decision whether to consider this attributable to management's decisions.
7. If sold for more than "book value per share", the premium will be shared by all resulting shareholders. Each share will have more assets working for it. EPS will be expected to increase. The increase should not be interpreted as "due to good management". It results from forces in the secondary market for shares, not management actions.

Stock options

• defer income tax for management.
• are not measured by the financial statements and so are open to abuse.
• are dismissed as a "non cash transaction" (see Cash Truths That Aren't) to gullible Retail Investors.
• are not long-term incentives because all kinds of events will trigger an immediate vesting - events that can be of management's own making.
• do not serve to retain management talent because the poaching business will cover the cost of options left behind.
• can be monitized (cashout without selling or triggering tax) by derivatives.
• will prompt share buybacks instead of the harder task of growing the business with reinvestment. No effort is needed to double the share price, when you can just buy-back half the shares.
• are free to management, in the sense that no money of their own is used to buy them. Nor have they paid tax on the deemed cost.
• are taxed at half the rate of wages. The company loses half their tax deduction.
• are recognized as ineffective by private equity, who require management to buy AND PAY FOR shares of a value equal to many years' salary.

The decision to buy back shares is a knee-jerk reaction by management, today. Management and the media say it returns value to shareholders; it is more tax efficient than dividends; it is an unambiguous 'good'. It isn't !!!

The decision to buy back shares should be the fallout from a thorough analysis by management of all the possible reinvestments for its earnings. The correct choice is the one yielding the greatest return. The possible investments, in order of highest probable rate of return, are:

A) The Core Business

Most businesses earn a return on equity in the 10-15% range. Reinvesting the earnings to grow the business is usually the best opportunity for the business and shareholders.

B) A New Business

The next best investment would be in another business with only an incrementally lower ROE.

C) Reduce Debt

Most companies use debt to leverage the return on invested capital into a higher return on equity (ROE) for shareholders. Reducing the debt will lower the company's risk, but will also lower the ROE. You need to compare the hurdle interest rate(%) to the ROIC(%) to see if debt is good or bad. (See discussion at Leverage).

D) Dividends

give the shareholders the decision where to reinvest. The company foregoes its own growth and implicitly declares it has no opportunities that can't be bested by the shareholder re-deploying into another company. Since business (generally) earns a ROE of 15-20% and shares trade at twice book value, the shareholder's long-term return is only 7.5-10%. The company has decided it has no opportunity that will yield even half what its current operations earn.

E) Share Buy-Backs... should be the decision of (next to) last resort.

1. If the share price is falling, companies should never buy-back shares - for the same reason you shouldn't buy them personally. Your investment is losing value, not earning any return at all.
2. While it is true that buy-backs are more tax efficient than dividends, the downside is that shareholders are given no choice to re-deploy into another company with a higher ROE.
3. Theoretically, the share price will go up an equal amount, so you can sell for an equal profit. But in practice, the share price does not respond so predictably.
4. The biggest problem with share buy-backs is that the media and analysts don't know how to factor them into their decision models; the accountants don't show them on any financial statement, and the media refuses to teach the public how to calculate comprehensive earnings.
5. The media further muddies the water by integrating the issue of stock options. Stock options and share buy-backs are two completely separate decisions and transactions. They should be valued and reported independently. They aren't though. So do it yourself.
6. The elephant in the room when the cash allocation decision is made is called MANAGEMENT OPTIONS. Because management compensation is now mostly by options, it is in their best interest to spend every penny on stock buybacks. The value of their options will rise without any business effort.
7. The return realized by the company on its investment in its own shares is the same as an individual shareholder's (the Earnings Yield = flip of P/E = ROE divided by the Price/Book). This is pretty poor. Over time it degrades the company's overall ROE. The media's simplistic argument that "since there are fewer shares, each shareholder's stake becomes larger" ignores the COST of that increase in EPS.

F) Purchase an Existing Business ... usually the worst option.

Buying out your competitor most often ends in grief. This is especially true if the business bought was publicly traded at a multiple of book value. Making it even worse is paying a premium to market value for control. Chances are high that the incremental return on the cost will be less than the purchaser's pre-existing ROE - which is why the cost of Goodwill is never expensed.

When the business purchased is private, and the purchase is paid for with shares that trade at healthy multiples, the probabilities of success rise. The incremental ROE will be much higher. This is why consolidators of fragmented sectors are frequently successful, at the start.

This is the most common way 'experts' dismiss the cost of stock options. Sure, the number of shares outstanding does not change when the company buys them back just as fast as they are issued. And sure, the excess cost to buy back shares is offset by the gain from selling your proportionate interest in the company. But ....

The following diagram shows a typical company's price structure.

The middle two columns reflect the two parts of a stock option exercise. The first reflects the gain to existing shareholders when they sell a part of their ownership in the company to new owners. The second reflects the cost of management compensation equal to the discount to market value. The right column reflects a share buy-back. The cost of the shares in the market exceeds what the company originally sold them for, so there is a loss.

What the 'experts' ignore is the column for Compensation. The company does not receive full market value for the options exercised. The opportunity cost lost is management's gain. This is not a 'victimless crime'. Selling shares of a company is no different from selling assets of the company. The shares represent a proportionate ownership interest in all the assets. Assets given away to employees are an expense to the company.

Buying back shares will never offset the cost of stock options. There will always be the discount to market value that is management's compensation.

See also how to integrate these numbers into Comprehensive Earnings Per Share.

When the same earnings are shared between a greater number of shareholders, yes, each will receive less of the earnings. But new shares are exchanged for $proceeds. Those proceeds are put to use generating additional earnings. As long as the proceeds equal the market value of the shares, the original owner should be indifferent. He will be in the same position as if he had sold that same % of his shares in the market.

Example:
The following example follows what happens to an owner when his company issues new shares at a market value greater than book-value, compared to the same owner who sells his shares in the market for a capital gain. He ends up in exactly the same position in both scenarios.

1. You start a business with $10,000 capital and 1,000 shares.
2. The $10,000 turns out to be very productive and the company is valued at twice as much: $20,000.
3. A new partner pays $20,000 for 1,000 new shares = half interest.
4. The company doesn't need the cash so it pays $20,000 out as a dividend ($10,000 to each partner).

So What Happened?
• The company is not changed by the issue of new shares. The book value of its equity is still $10,000. Its market value is still $20,000.
• Except it now has twice the number of shares outstanding - which doesn't make any difference.
• The owner
  1. Seeded capital = $10,000
  2. Received $10,000 dividend which left him with a
  3. Cash cost = $0, and an investment of
  4. 50% share in a $20,000 investment = $10,000.

Compare this to selling half his shares in the secondary market. For 500 shares a buyer would pay $10,000, leaving the original owner with the same cash cost = $0 as the first scenario, and he would still have a 50% equity interest in a company worth $20,000 = $10,000.

Conclusion: As long as the company receives full market value for new shares, you are fairly compensated for giving up ownership in the company. You 'realized' a capital gain from the 'sale' of your ownership. This is exactly what happens when you see "Dilution Gains" on a company's Income Statement. It is not an oxymoron. Their subsidiary has issued more shares, so their ownership is diluted. But they realize a gain because the assets now working for them has increased.

When the 'capital gain' is retained in the company instead of being distributed as a dividend, it will be put to work increasing future EPS. This should not be interpreted as the result of great management. The company is now bigger than before, but not better. The gain is a function of the market price for the shares, and market sentiment. It has no grounding in the fundamentals within the business.

The increase in EPS resulting from the reinvestment of this 'capital gain' is at the root of the problem when measuring the cost of options. Remember that issuing new shares is just financial manipulation. It does not create value. Always separate the effects of share issues from the effects of options.

In 2004 there was a concerted effort to force companies to measure the cost of options, and include the expense in the Income Statement. Users of Financial Statements lost the battle. Companies and their accountants won. Yes, options are now measured, but not correctly. Now you must cancel out the incorrect accounting as well as measure the options cost yourself.

First ask: "what is the cost to the company, of compensation paid as options?".

1. Can the whole thing be ignored because it is a non-cash transaction?
2. Is the cost to the company the same as the benefit received by the options holder?
3. Is the full cost of options determined at the time of their grant?

1. The cost of options cannot be ignored just because it is non-cash. There is no such thing as a non-cash expense. Either there is a barter transaction that should be considered two separate cash transactions, or there is a timing difference between the cash transaction and the reporting period. This argument is expanded on the Cash Truths page.

2. Companies take the position that the total benefit realized by management from options is NOT a cost of the company. They claim the cost to the company is measured by the Black-Scholes formula at the grant date. They say that the increase in an option's value as the stock price increases, comes from 'the market', not the company. Therefore no additional expense need be recognized after the date of issue. This logic fails on analysis.

The parties on opposite sides of an option contract are equal and offsetting. Options are a zero-sum game - one person's gain is another person's loss. When management benefits from the option someone must lose. That someone is the business. The company cannot get rid of its option liability without either paying someone to assume it, or settling it. At no time does 'the market' assume the liability. Yes, the increase in an option's value is DUE TO the market's pricing, but the increase in value does not COME FROM the market.

Another way to support the argument (that the benefit to management is exactly the same as the cost to the company) is to consider a business where the owners and managers are one in the same people. No one ever suggests that this management should be compensated with options. Everyone realizes the cost to themselves as owners would negate any gain to themselves as managers.

3. All options contracts have two transactions - the original creation of the contract when the premium is exchanged, and the final settlement. It cannot be argued that the company is the counterparty to one but not the other. The full cost of options compensation cannot be known at the time of their issue. The future is unknown until the contract is settled and closed. The two transactions together (the opening payment of a premium and the closing settlement) determine the total cost.

Financial Statements record as a company expense only the opening transaction - the calculated value of the premium. This valuation never changes, and the closing settlement is completely ignored. This violates the basic concept of the Balance Sheet which is supposed to measure the value of the assets/liabilities AT EACH POINT IN TIME. Correct accounting would re-value the option according to its changing intrinsic value due to a changing stock price.

...............................

An analogy may make this more clear. A company purchases goods from another country, payable in that other's currency. The cost booked at the date of purchase uses the exchange rate at that date. But when the company eventually receives the goods and pays the bill, the exchange rate will be different. The final cost to the company is the exchange rate on the date paid. Similarly with options, the cost of options is the intrinsic value on the date they finally are exercised. Their cost is not determined at the date they are granted.

...............................

One excuse for NOT adjusting the cost of the options is that a decrease in the stock price would result in a negative compensation cost. Some think this would be unacceptable, but do not say why. The stated objective of this type of compensation is for management to 'participate' in the fortunes of the shareholders. When profits decline .... the stock price is expected to fall .... which decreases the value of the options .... which decreases the compensation expense .... which decreases the hit to profits for outside shareholders. That is just what is wanted.

The same system of participation (both positive and negative) is used to record income taxes. When the company loses money, the government 'participates' in the loss. A negative tax expense is booked that reduces the hit to profits for outside shareholders.

The Correct Measurement of Options Compensation

Any measure of the costs of options must measure both the value of the options exercised and the change in value of options outstanding (a liability). The process is similar to measuring 'cost of good sold' -- Opening Inventory + Purchases - Closing Inventory = Inventory Sold. In the case of options the value of each (opening, closing, exercised) is the "intrinsic value" -- the difference between the market value (at the current date) and the strike price of the option.

Closing Liability - Opening Liability + Exercised = Compensation Expense.

The exercise of stock options is as if the option-holders (not the company) could force all existing shareholders to give up a percentage of their shares at a price below market value. Diluted EPS measures only a proforma reduction in EPS based on the options outstanding at the beginning of the reporting period. This measure ignores the options outstanding at the end of the period. It ignores the increase in dilution caused by any increase in stock price since the beginning of the year. It ignores the lost value to existing owners from the options exercised.

...............................

A better metric for measuring the impact of options dilution answers the question "What % of future earnings growth (before options expense) goes to the holders of stock options and not me?" Or put another way. "What % of reported earnings growth (not earnings) would disappear if options were measured correctly?" After all, no one invests for earnings. We invest for earnings growth. This metric is equal to

(% options dilution)  ×  (P/E ratio).

E.g. if the options outstanding equal 5% of the issued shares and the P/E = 20, then (5/105×20 =) 95% of any increase in earnings goes, not to the shareholders, but to the options holders: a HUGE cost. If the income was correctly stated most of the growth would vanish. Without an increase in EPS, the stock price would not go up, and the options held would not have gained in value. The emperor has no clothes, and investors must stop giving him their money.

Proof: Assume

• The number of options outstanding is 5% of the issued stock.
• The P/E is stable over time at 20.
• The published earnings to start are $1.00/share, so the stock trades at $20.00.
• The exercise price of the options is $20.00, so the liability (intrinsic value per share) for options is $0.

What happens if the earnings increase 10%?

• Published EPS increases $0.10 to $1.10.
• The stock price increases $2.00 from $20.00 to $22.0.
• The options value will now be (22-20 =) $2.00.
• That liability 'per share' is (5 / 105 × $2.00 =) $0.0952 / share.
• If that increase in liabilities were booked as an expense it would cancel out (.0952 / 0.10  =) 95% of the increase in earnings.

...............................

But earnings DO increase when companies use options !!! Yes, but not when there are share buybacks to cancel the increased number of shares outstanding. Share buybacks would crystallize that $.0952 unbooked options cost in a real transaction (although not on the Income Statement).

Earnings can increase in spite of options' costs when there are no offsetting share buybacks. This is because the company gains from a share-issue-premium. That gain offsets the cost of options. Remember the diagram from above:

The cost of the options here is the $5 reduction from the $15 market value. But the share-issue-premium of $10 is big enough to more than offset the cost of options. That $5 excess share-issue-premium will boost future earnings. Its existence is not an excuse though, for failing to report the true cost of options. The cost of options and the share-issue-premium are two completely separate and distinct economic events. Shareholders are only indifferent to the issue of additional shares when they sold for market value. Discussed in #4 above

(i) Many investors prefer shares that pay dividends because they think the cold cash 'proves' a company's earnings. This thinking ignores the reality that it is easier to raise cash by selling assets, than it is to earn it. Distributions to shareholders can more easily be a 'return OF equity' than a 'return ON equity'. Dividends do not 'prove' earnings - earnings 'prove' the sustainability of dividends. This is discussed at CashTruths. Also, when management knows that distributions will be recyled back into the company via DRIPs (dividend reinvestment plans), they can distribute more than what they can fund.

(ii) That same belief that dividends are 'cold cash proof' falls down from another perspective. What must the investor do after receiving this cash? He must reinvest it back into the market. Immediately he exchanges the hard cash back into a paper asset of volatile value. He is left in the same position he started from.

(iii) Retail Investors think the dividend is a kind of 'extra', that their choice is between x percent growth PLUS a dividend, or just the x percent growth. They do not realize that the dividend comes AT THE EXPENSE OF growth. It is a transfer of wealth from the company to the shareholder. While the shareholder then has cash in his pocket, the value of his stock holding has fallen equally.

(iv) It is common to hear the argument supporting a preference for dividends that says "dividends account for 97% of investor returns". This argument deserves a section all of its own below.

(v) Another argument stresses the contribution from dividend income by deconstructing the components of 'real' returns - with inflation removed. The game they play is to subtract inflation from only the capital gains, leaving the dividends intact. This makes the dividend portion seem much bigger. But why? Certainly owners of debt explicitly consider inflation to eat into the value of interest payments. So why does inflation not eat into dividend income?

Inflation eats into all returns, whether paid as dividends or realized as capital gains. When the total return comes from more than one source it is meaningless to attribute all the effects of inflation to either one or the other. It is only meaningful to subtract it from the total return. But even the academics use this sophistry.

Examples of this belief - Table 4 of Dimson, Marsh and Staunton's paper from which they ... "reinforce the point that the dividend yield has been the dominant factor historically". See also the Market Oracle. See also Exhibit 3 of GMO Montier's article where he subtracts inflation from the growth component - essentially capital gains.

(vi) Investors are skeptical about management's use of retained profits. They think profits will be wasted on executive jets, etc. You can find this belief right back in Benjamin Graham's 1934 classic. But his statment of 'fact' is justified only by 'if it were studied it would be found ...'. In reality companies earn handsome rates of return on those reinvested dollars. The long-term US average is 11%. You check the data on Sheet 31 of the data spreadsheet.

The economy has its ups and downs. The turmoil of the 1930s explains Graham's belief, but times change. Going forward from 2010 you must form your own opinion. Investors' correct preference (reinvest or pay dividends) should be decided by the opportunities each company faces. If it can earn 15% in a world where the investor can only earn 10%, the earnings should be retained. Since investment opportunities vary the dividend paid should also vary.

(vii) Retail investors like dividends because they provide a simple and easy substitute for proper security analysis. They think of the dividend yield as an 'interest rate' equivalent. They are encouraged to ignore the ups/downs of the stock's price with the assurance that in the long run, the stock's price will always go up. But a full year's 4% dividend is easily swamped by a 20% drop in the stock price, often within weeks. The dividend yield says nothing about the certainty of its continued payment. A high yield may represent a good deal, or a disaster in the making. This kind of short-cut analysis is shortsighted.

(viii) Some dividend die-hards have now moved the emphasis away from the size of the dividend toward a company's history of dividend growth. This is the metric used to generate lists of "Dividend Aristocrats". Their use of the term 'dividend growth' implies that it is different from what we normally call 'growth' - growth in assets, growth in earnings, capital gains,etc. In fact it is NOT different. Sustainable increases in dividends can only come from growing earnings. Over short terms the company can increase the pay-out ratio (portion of earnings paid as dividends) but it will soon run out of earnings. Over time market valuations normalize so that capital gains follow earnings growth. Growth is growth is growth.

As expected, the Dividend Aristocrats do not usually pay high dividend yields. The growth in dividends must come from growth in earnings ..... which must come from reinvested earning ..... which means low dividend yields.

(ix) As profits collapsed in 2008 it was common to hear dividends-paying stocks recommended because "you get paid to wait" for the price to eventually recover. But the dividend comes at a price. The company loses liquidity in an illiquid world. The company may be forced to issue additional equity that will permanently dilute your prospects of recovery. The company may miss opportunities to buy-up floundering competitors in an once-in-a-lifetime opportunity. All because investors themselves have locked management into a policy of sustaining the dividend at all costs.

(x) Retired investors claim they need products producing cash flow because they are now living off their investment returns. In reality no investor's portfolio is completely static. It is regularly traded or rebalanced. At each time the investor can choose to NOT reinvest a portion for withdrawal. To presume that investments must be 'sold' to fund their cost of living is wrong. The probability is that retired people will keep a much higher balance in their bank account because they do not want to be always worrying about overdrafts, and the regular top-up from the paycheque is now missing. Withdrawals from the investment account will not be frequent and will be fairly large.

(xi) An argument is made that, when you will be wanting to own dividend stocks in retirement, you must also own them during the accumulation phase. Supposedly the switch at retirement from growth to dividend stocks will trigger capital gains taxes and reduce your portfolio. There are three counter arguments.

1) Except for the rich and those receiving inheritances, the vast majority of Canadians' retirement savings are in tax-sheltered accounts. Taxes are irrelevant. 2) Assuming they are not in tax-shelters, any dividends paid during your working years will be taxed yearly and at your top tax bracket. Capital gains can be deferred. 3) Almost nobody holds individual growth stocks for the 10, 20 or 30 years of accumulation. The normal turnover of securities will trigger capital gain tax gradually over the period, long before the date of retirement. The normal turnover of securities will happen in the dividend portfolio as well, with the same effect.

(xii) Dividends are frequently promoted with the claim that they are taxed at the lowest rates. This may be true for an individual, but is not true as advice without qualifications. When the portfolio is inside a Canadian RRSP, or RESP, or a TFSA taxes have no impact because there is no tax paid. When the investor is being caught by Canadian Minimum Tax all income is treated the same. Again, at the top marginal tax bracket dividends are taxed at the same rate as capital gains. (See current marginal tax rates on different types of income.)

(xiii) There is back-testing to show that portfolios of the highest yielding stocks outperform lower yields and the general market. This promise of higher returns may be the prime driver of the (now current) preference for dividend stocks. But if returns actually being realized were beating the market, why do the dividend-believers resort to quoting results with their 'dividend on cost' metric? Why not report with the metric that is accepted by everyone? And why do they decline to disclose their total returns with the excuse that they never look at the portfolio's value? The comparison of ETF returns is charted on the Screening page - showing a mixed bag of results.

(xiv) Many believe that a steady $$dividend in a period of stock price volatility, allows the reinvested dividend to purchase more shares when the stock is down, and less shares when the stock is high, producing extra returns from a dollar-cost-averaging effect. There is no certainty of this effect. It depends on the timing of the market during the holding period. When the market falls after purchase and recovers later, then there is an excess return earned from the dividends buying a larger number of additional shares. But when the market rises after purchase and falls later, then returns are reduced. The effects in both situations are reduced when you assume that high-dividend stock prices fall less in down markets. You can follow the different situations in the Dividend Vs Growth Portfolio spreadsheet.

...............................

A company has a choice of four ways to use earnings. A simple example (following) compares the investor's returns under each option. For the two options where investment remains in the business, the investor realizes twice the return (20% equal to the company's ROE), compared to when profits are used to pay dividends or buy back shares (10% and 11%).

You many be tempted to argue that (B) Receiving a dividend and then using it to purchase more shares would be the same as (C) DRIPS. The distinction is that DRIPs increase the company's equity by reinvesting inside the business. Whereas purchasing more shares from the secondary market has no effect on the company itself. A dollar inside a business earning 20% ROE is worth twice as much as a dollar held by investors earning only 10%.

DRIPs put the investor into the same position as if the company had kept the cash and reinvested earnings (D) without ever paying a dividend. The cash does a circuitous route out to the investor (triggering his personal tax) and then back into the business. Of course there were transaction costs along the way. Reinvesting profits without the pretense is more efficient. Pundits promoting dividends as well as DRIPs are talking through their hat. They are the exact opposite of each other.

The box (A) Buy Backs presumes the shares were bought at the beginning of the year before earnings had the effect of raising the stock's price. If bought at the end of the year, the stock price would have risen to $120 so fewer shares could be retired. The investor's return in that scenario would be 9%. If you average both scenarios (9% + 11%) you get the same return as the investor receiving 10% dividends.

...............................

Of course there are some good points in favour of dividends.

• Many Canadian testamentary trusts are set up to distribute income to a surviving spouse during his/her lifetime. On their death the next generation is given the residual principal of the trust. If the trust earns no income (dividends or interest) there is nothing to distribute. So trusts are correctly heavily weighted with high dividend paying stocks.
• All Canadians not in the very top tax bracket, get taxed on dividend income at a lower rate than capital gains. See the spreadsheet comparing the average and marginal tax rates for different tax brackets.
• The requirement to pay dividends keeps management's attitude correct. They would love to simply take the cash from common share issues and then see the back of those 'owners'. Dividends keep it clear that management works for those owners, that those owners demand a return on their investment. The replacement of dividends with share buy-backs removes that attitude correction. Although technically equivalent, they are not transparent, or considered an ongoing commitment.
• Dividends have a great emotional wallop for the investor. Getting the cash just feels good. When in retirement and withdrawing cash, it is emotionally easier to withdraw cash from dividends than from any purposeful sale of shares. Many people emotionally 'feel' that asset sales deplete capital while dividends leave capital intact.
• Healthy dividends prevent some of the games management play using equity for compensation. Option holders do not receive any dividends. And dividends reduce the capital gains on options. (Of course the compensation can be structured to come from dividends instead, or to increase in offset to any dividends.)
• There is no question that hefty dividends support share prices when the economy tanks and profits fall. When cash is being withdrawn in retirement the 'sequence of returns' affect is more deadly the farther a stock falls, so a non-volatile stock price reduces the damage. As well the dividend $$ itself helps fund the withdrawal - reducing the need to liquidate securities at their lows. Look at the second sheet of the Dividend Vs Growth Portfolio spreadsheet where cash draws are modeled.
• It is during market corrections that stronger businesses use the opportunity to purchase weaker competitors. They must pay with cash or debt or shares. The dividend-paying business will not have the cash, but its share price may be relatively more strong because it was propped up by those dividends. As shown throughout this website, shareholders benefit from new share issues for good ROE opportunities when the stock is trading at multiples of book value.
• Dividends to common shareholders provides a cushion for preferred shareholders. Most often the common's dividends must be cut before management can cut the preferred's dividends. This ensures public notice of the cut along with the ensuing loss of management credibility. It also ensures that the people with votes are truly pissed off before the preferred owners get their dividend cut.
• Short-sellers of the stock must make good on all dividends issued by the shares they sold. This cost adds considerably to the cost and risk of short-selling. Keeping short-sellers at bay may be considered either a good thing or a bad thing.

The dividend true-believers promoting a dividend-growth strategy are firmly attached to the Yield On Cost (YOC) metric used by no one else. It is a calculation of dividend yield that leads long-term holders of a stock to believe they earn a higher yield than new purchasers. Its users are very resistant to learning that their calculations are a delusion. They claim their metric is meaningful because they disclose the calculation and their math is correct. An analogy would be the person who re-calibrates his bathroom scales below zero, then brags about his weight loss, and truly believes he has lost weight. His conviction holds even as he discloses his re-calibration.

...............................

There are different ways to calculate the metric. The numerator is the same used in the normal 'current dividend yield' - the next 12 months of regular $$ dividend payments. It is the measurement of cost in the denominator that varies. In its basic form 'cost' is the historical price paid for the shares.

Example:

• You buy the stock for $20 with a 4% current yield paying $0.80 dividends.
• Years later the stock you still own now pays $1.20 in dividends.
• Your YOC is now $1.20 / $20 = 6%.

This calculation creates a metric that is influenced by three factors. There is no way to tell which factor has caused the resulting value.

1. It gets larger as the dividend increases with earnings growth, stock price growth and a stable current yield. In the example, the stock's price may have also increased 50% to $30, so the current yield remains 4% (= $1.20 / $30).
2. It gets larger if management increases the dividend by increasing the payout ratio. This may be due to fewer economic opportunities or investors' preferences, or signaling future growth. In the example, the stock's price may still be the same, but the payout ratio has increased 50%. The current yield would be $1.20 / $20 = 6%.
3. It gets larger the longer the investor holds the security, allowing the first to factors to accumulate.

One variation on the calculation of YOC is common because it results in a larger resulting metric. The 'cost' in the denominator is reduced by all dividend $$ received. Those investors who DRIP their dividends have the easiest time keeping track. For them the historical cost of the additional shares is offset by the reduction for dividends received -- so they simply ignore the cost of all the additional shares.

These investors treat their dividends as both 'income' AND 'return of capital' - at the same time. That is the same as forgiving someone's debt to you equally with every dollar of interest they pay you. There must be supplicants lined up out the door to borrow from these people.

A second variation on the calculation of YOC allows the dividend true-believer to escape the nasty effect of selling a stock for capital gains. The replacement stock now has a larger historical cost and the investor's YOC has shrunk back to everyone else's current yield. What to do? Pretend you never swapped stocks. Just continue using the historical cost of the stock now sold. Who cares that the basic premise of the metric is now destroyed? The dividend true-believer does NOT want to celebrate capital gains.

When YOC is applied to a portfolio in total it uses that same fudge. The portfolio's value at some point in time is taken for the 'cost' and continues to be the 'cost' no matter that stocks are bought and sold within it. And all those savings added along the way? Well of course any additional dividends generated are included in the metric, but there is no need to adjust 'cost'. Surely?

...............................

So, what does YOC measure? Good question. Just defining the math does not answer the question. What is the economic reality it measures? You can ask this question until you are blue in the face without getting an answer. The metric cannot be compared to any other financial metric measuring past returns or future growth. All normal metrics measure the change in some attribute over a period of time, relative to the principle dollars invested during that same period. When calculating a yearly return, the principal invested during that year is used, not some arbitrary value from the past.

Here are the situations in which you hear YOC used.

1. Most often someone throws their own very high YOC into a conversation where it's obvious intent is to impress you with the high number. Whether or not they disclose that it is YOC (not the current yield) you are clearly meant to compare their metric's value to your own smaller 'current yield', and conclude that they are investing gurus. E.g. colt45's comment: "The market is down 10% this year and I am up 9%. My stocks pay me between 5% and 10% based on what I paid for them."

   But the investor who has held a stock for years is never any better off than today's purchaser. This point is proved with a thought experiment. Pretend your broker made a mistake and sold your shares today, only to catch the mistake and reverse the transaction. You will not be aware of the transaction because your economic position has not changed. You would

   • own the same value of the stock
   • hold the same number of shares
   • receive the same value of dividend.

   But now your cost is the same as the current market price - and your YOC is the same as the 'current yield'. If you never learn of the transaction you may continue to brag about that outsized YOC - your own personal delusion.

   Too often you hear investors making very bad decisions based on this use of YOC. E.g when a company's prospects change and the stock should be sold, the long-term owner says "Oh, I can't sell my stock NOW. I'm earning a huge yield and I couldn't match that with anything else". He decides to not sell because his YOC will fall.

   The way to convince him this is wrong is to change the discussion from 'percent yield' to 'dollars of dividends'. Show him that the proceeds from the sale would buy new shares that generate the same $$ of dividends.

2. Another users of YOC claim it is a psychological aid helping them NOT sell their securities. This can only work if the users believe their large metric shows they are better off than other investors. It is ludicrous for them to claim in the same breath that they don't really think the metric measures anything real. Either they believe it or not. If they don't then there would be no psychological effect.

   It should not be an objective of any investor 'to hold securities for the longest period of time'. You invest to increase your wealth and fund future needs. You are no closer to those goals when you hold the same security for a longer period of time. There is no payoff. With few exceptions the fortunes of companies ebb and flow. What is blue-chip today will not be tomorrow. You might even benefit from tax-loss selling good stocks.

3. Other users claiming psychological support from this metric to 'feel good' cannot articulate what behavior is changed by its use. You can only assume that their use of YOC has prevented their use of proper metrics to correctly evaluate their investment returns. But without the truth they cannot make changes to their strategy or learn better methods. It is never better to shield yourself from the truth in order 'to feel good'.

4. Sometimes YOC is defended by claiming it allows for comparison of returns from equity vs. debt. They say "The 4% debt I bought ten years ago is still generating the same $40 yearly. But the equity I bought with the same $1,000 has increased its dividend from $20 (2% yield) to $60 giving me a 6% YOC. See how superior dividends are."

   But YOC ignores the actual payments over the period in question. It implies that the 6% was paid every year. But if the increase to $60 happened only in the last year, you would come to the wrong conclusion. The debt would have been the better investment. 10 years of 4% is greater than 9 years of 2% plus 1 year of 6%.

5. There are some users of YOC who defend its use (instead of the normal 'current yield') by redefining it to BE the 'current yield'. They include qualifying phrases like "YOC using the yield when the stock was purchased" or "YOC using the stock's current value". I guess this is a case of "If you cannot beat them, join them - just don't admit it."

6. There are user of YOC who are doing nothing but running in circles. They use normal financial tools to evaluate situations, then translate the situations into YOC, and then translate the YOC back into normal metrics that are meaningful.

   E.g. some claim that YOC allows them "to see what kind of growth I'm getting on my portfolio." Imagine a situation where
   * Last year's portfolio received dividends = $300.
   * This year's portfolio received dividends = $350.
   Normal finance would calculate the growth as (350 - 300) / 300 = 16.7%.

   In order to use YOC you would need three three additional steps.
   * Keep track of the cost of the portfolio at some point in history (say) $5,000.
   * Calculate the YOC for last year = 300 / 5,000 = 6%
   * Calculate the YOC for this year = 350 / 5,000 = 7%.
   Then calculate the growth as (7 - 6) / 6 = 16.7%. Nothing was accomplished by adding the three additional steps. The answer could have been calculated directly without any recourse to YOC.

7. There seem to be endless defenses of YOC that involve recounting the historical stock prices and dividends paid of selected companies. At the end of which the great results are attributed to the YOC metric. As if a metric that measures something actually causes the historical performance of a stock. E.g. "YOC allows me to spend $1,000,000 today rather than $3,333,333 in 10 years, to end up with the same annual income." As if growing the portfolio's value at 12.8% yearly is questionable (it is) but growing dividends at 12.8% yearly is a perfectly safe assumption because of the wonders of the YOC metric.

8. Then there are the users who simply state "I find YOC on cost relevant. Period. And my opinion is as valid as the next guy's."

9. You can work your way though the list of defenses offered by the commentors on this bulletin board thread. Each one is simple to prove wrong, if not ludicrous.

Advising clients to buy high dividend stocks may be good advice, but advisors are lying when they quote the 97% number (or even the 60% number). They should find honest reasons to support their advice.

What Is Relevant

If the current dividend yield on your portfolio is (say) 3% and you demand a 10% return for investing in risky stocks, then 30% of your expected return will come from dividends - 3% as a portion of 10%. This does NOT change the longer you hold your portfolio. Each year is calculated anew with the current dividend yield. And history is just the sum of all individual years.

If you choose to own high dividend stocks, the portion of your expected return from dividends will be higher than for the person who chooses low dividend stocks. Neither choice necessarily influences their total returns. During a market pull-back a greater portion of the total return will come from dividends than during a fast growing market.

If that common sense argument does not convince you, consider the implications of the claim for retired investors. If it is true (that reinvested dividends account for 97% of your return) then retired people who are spending their dividends (and not reinvesting) must be earning only 3% of their potential. Garbage. Investors earn the same rate of return regardless what they do with their dividends, regardless what they do with their capital gains for that matter.

What Is Irrelevant

Historical dividend yields are irrelevant - along with their ratio to total returns. There are two long-term trends that will not revert to any mean.
1) The use of stock options for compensation has permanently changed management's motivation to pay dividends.
2) Stock buy-backs have replaced dividends because of their flexibility and because analysts now treat them as equivalent to dividends.
Times have changed. What happened in the past is in the past.

The following graph compares yields vs capital gains as they have changed over time. It uses 5-year averaged returns in order to smooth the inherent volatility of capital gains and better show the relationship to dividends. From 1957 to 2009 the TSX return from dividends has equaled 37% of the total return. There is no cyclicality showing here to cause you to conclude that the relationship is mean-reverting.

Even these statistics overstate the impact of dividends. The measurement of dividend returns used includes both 1) the actual dividend payments from the index, plus 2) the capital gains earned from reinvesting those dividends that were paid earlier in the year. See the math at this spreadsheet.

The advisors who quote the statistic ("dividends provide x% of total returns") always present it as a reason to prefer dividend-paying stocks, implying higher returns will result. But there is no logical link between the two issues - no matter what correct percentage is used. Some of the investors in that historical period owned growth stocks and earned the benchmark return without any dividends. Other investors in that historical period owned high dividend stocks and earned the benchmark return with a much larger percentage coming from dividends.

The experts who have changed their argument from "97% of total returns" to "40% of total returns" still present the fact as a reason to prefer owning high dividend stocks. See this example from James Montier. But if dividends earn only 40% then capital gains must earn 60%. Since 60% is bigger than 40% why are the experts not promoting growth stocks instead? None of this argument makes sense. Note that Montier did not change to the 40% number because he realized Siegel's graph was wrong. He used Siegel's exact logic but shortened the time-frame so that his 40% did not have sufficient time to become Siegel's 97%.

What Is Flat Out Wrong

The 97% claim comes from a book by Jeremy Siegel ("Future for Investors" pg 126). The quote is "From 1871 through 2003, 97 percent of the total after-inflation accumulation from stocks comes from reinvested dividends. Only 3 percent comes from capital gains." He compared the portfolio value resulting from $1 invested in 1871 in a 'total return' index to the same $1 invested in a portfolio whose dividends were removed (what we are familiar with as a 'normal' index).

Over 133 years the difference between the two widens until by 2003 the portfolio without dividends is worth only 3% of the value of the 'total return' portfolio. He presented a graph looking like the one following and concluded that the area between the two lines was the return from dividends.

1: The original claim is being mis-quoted by the media and advisors. See again how Montier talks about "43 percent of S&P returns". Siegel did NOT say "97% of your returns". He said "97% of accumulation". He was NOT talking about 97% of the rate of return. He was talking about 97% of the resulting portfolio value. 2: Accepting what Siegel actually said, was his conclusion correct? No.

Graphic Proof

You can chart the exact opposite logic used by Siegel. The value of the Total Return Index would remain the same. But instead of the lower line measuring the normal Index (the portfolio with dividends removed) now the lower line measures what would be the value of the portfolio if capital gains were removed each year.

This graph shows reinvested capital gains accounted for 99% of the accumulated portfolio. Is it logical to claim that 96% of Total Returns come from dividends, AND 99% of Total Returns come from capital gains? Of course not. Neither graph measures the income split attributed to dividends or capital gains. The only thing both graphs DO show is the importance of reinvesting profits - from whatever source.

Math Proof

Look at Box (C) in the spreadsheet (Excel or OpenOffice). What Siegel labeled as the value attributed to dividends is just the mathematical difference between the values of the two indexes (column E). But the same value can be obtained by considering it to be a stand alone portfolio (column F). Put the cursor on the spreadsheet's cells to see that the calculation used increases the portfolio each year by the total return earned by its own investments (mostly capital gains plus any dividends), PLUS the capital infusion equal to the dividends of the S&P index.

Another Way To Explain It

Start by simplifying the issue. First, reverse Siegel's decision to measure portfolios 'after-inflation'. Inflation does not change the essence of any conclusions. Second, present the graph with a log scale so the hockey-stick effect is hidden and the portfolios' growth rates are represented by the lines' slopes. Third, measure 1926 to 2007 because that is the period for which there are public numbers.

Now interpret the resulting graph above. The top line measures the Total Return Index, reflecting a portfolio where no capital is added or removed. The profits compound untouched. The bottom line measures the normal Index, reflecting a portfolio invested in exactly the same stocks, and earning the exact same rate of return. Its growth rate (slope) is lower than its rate of return because capital is removed each year equal to the dividends earned. The difference in the portfolios' growth rates (slope) equals the 4.2% return from dividends (= 10.2% - 6%). Over this period dividends provided 41% of the total return (= 4.2 divided by 10.2).

How should we interpret the Difference between the lines? Think of the Difference areas as a portfolio of its own, whose value has been stacked on top of the Index portfolio. It would be more clear if the Difference portfolio were charted with its own baseline, so we can see its growth alongside the growth of the other two portfolios. This Difference portfolio is add as the red line below.

The Difference portfolio is funded each year with the dividends earned by the Total Return portfolio. It invests in exactly the same stocks as the others. Its rate of return from both dividends and capital gains is exactly the same as the others. The only thing that differentiates the three portfolios is the capital added each year to the Difference portfolio and removed each year from the Index portfolio. The Difference portfolio's growth (slope) is the highest, at all times, by definition, because of the added capital. The Index portfolio's growth (slope) is the lowest, at all times, by definition, because of the capital removed.

Conclusion: The size of the Difference area on Siegel's graph has nothing to do with 'returns from reinvested dividends'. Nor has it anything to do with 'accumulations from reinvested dividends'. It grows mainly from its own profits (dividends and capital gains) just like the Total Return portfolio. It makes no difference what dividend yield is paid by the Index portfolio. Even a paltry 0.5% dividend yield would result in a graph looking essentially the same. It makes no difference if the capital added equals the dividends or the capital gains earned by the S&P index. In all cases the Difference portfolio will eventually become 99.99% of the Total Return portfolio's value because its slope is steeper from capital injections, not due to the magic of dividends.

Conclusion

You must be aware that even academics can be full of hot air. Retail investors should smell a rat when they read the nonsensical statements like the following from Dimson, Marsh and Staunton, based on the same idiotic interpretation of Siegel's graph. "Dividend income adds a relatively modest amount to each year's gain or loss. But while year-to-year performance is driven by capital appreciation, long-run returns are heavily influenced by reinvested dividends. .... The longer the investment horizon, the more important is dividend income. ... Capital appreciation dwindles greatly in significance [over time]".

Say what? How exactly do they think this magical transformation occurs? It is common sense that long-term results are only the sum total of each year's results. What is consistently true for each year will be true over long time periods.

This idea that any one year's capital gain turns into dividend income if you just look back at it from a long-enough time span, gets trotted out by many people. See Exhibit 2 of the GMO Montier article. Lies, damn lies and statistics."

© www.RetailInvestor.org

NEXT | HOME