The Importance of Dividends

Several events over the last few months have led to me to question the importance of declaring a dividend for any invested company. After all, as shareholders, what better reward should we expect than an immediate cash “return” on our investment in the form of a dividend ? As I was attending AGMs and EGMs, shareholders of all shapes and sizes and ages would almost invariably come up with this million-dollar-question: will the dividend increase next financial year ?

To begin to analyze this seemingly innocuous question, let’s first take a look at what a dividend represents. A dividend is simply an appropriation of a company’s retained profits and earnings from the previous financial year, which they are paying out a portion (say 30-50%) in cash to shareholders. This payout is entirely optional as Management is not contractually bound to pay out any part of the company’s earnings as dividends, unlike in the case of bonds (or debentures) where interest payment obligations have to be met. Thus, most of the time, a dividend payout is a signal that Management either wishes to reward shareholders for their loyalty (and themselves too, as most of the time Management and Directors do hold shares of their own in the company) or has too much cash on hand which they don’t know how to make good use of. Let’s take it part by part.

Management says in the first example that dividends are a way of rewarding shareholder. This is well-supported because as the business takes off, the earnings, revenues and margins of the company also increase, thus increasing the total shareholders’ “value” in the company. The value is then crystallized in the form of dividends, which represent a return on what the shareholders had originally invested in the company. Looking at it from this angle, it seems perfectly justified. However, an informed shareholder should also note the company’s cash flow requirements (such as for capex and future capital commitments) and ensure that Management is not paying out more than it should. This is a difficult aspect to determine as usually only the insiders know how much funds the company needs and how much it can disburse as dividends, but a good estimate would come from the nature of the industry, the company’s strategies and the capital commitments note (from the Annual Report).

In the second example, Management gives out cash as a special or one-time dividend because they have too much cash sloshing around and they have no better use for it. All I can say is Management is probably not confident of putting the money to better use, which is why they would rather give it back to shareholders. This is not necessarily a good thing as it may indicate that the company has entered the mature or even decline phase of the business such that its products have a stable (rather than growing) demand and sales may even start to stagnate or taper off. Most companies that I have noticed which pay out a special dividend may do so due to the aforementioned reason, or due to the sale of a property or shares in an investment. Shareholders should not invest in a company hoping for such “one-time” payouts, as this may imply the company’s business may be on the decline and that they are considering divesting and moving into another. Carefully scrutinize the business of each company you intend to invest in so as to avoid this costly mistake. Otherwise, the dividend gain may very well be offset by the capital loss !

Another form of dividend which may be declared is a dividend-in-specie. This in essence is a share dividend, meaning a dividend in the form of shares in another company rather than in cash. One recent example is Boustead’s dividend-in-specie in the shares of Easycall International Limited (now renamed as China Education Limited) of about 3.14 cents/share. Ezra had also initially intended to dividend out its shares in EOC Limited to shareholders in the form of a dividend-in-specie, but later decided to sell the shares away as vendor shares in order to raise more funds for expansion. The advantages of this exercise are that shareholders get to hold shares in another company which may have its own growth prospects as well. The downside is that such companies may also have dormant or stagnant business models with little growth, thus “trapping” your investment for many years. In Easycall’s case, it was bought over by Raffles Education Corp and the shares soared from a low of about 8 cents to a high of over 90 cents, returning about a 1000% gain to those who faithfully held on to them. But this is more of an anomaly than the norm, and shareholders should remain cautious about dividend-in-specie announcements.

To summarize, dividends are a double-edged sword as it can be either a good or bad thing for a company depending on the context and the company’s business cum industry. There is no right or wrong and each case should be evaluated on its own merits. For high-growth companies such as Swiber, for example, it will be much better for them to retain earnings rather than pay out dividends as they can use the cash more efficiently to grow the business. Reinvested dividends can help to grow a company’s intrinsic value and if this is the case, then the argument should be made for no dividends until the company has reached a stable rate of growth (becoming a cash cow). For the record, Berkshire Hathaway (Warren Buffett’s holding company) has NEVER paid a dividend (except only once which Buffett admitted was a mistake), but has seen the value of its shares soar to as high as US$100,000 per share. Thus, there is really no limit to share price appreciation as long as the business is growing and earnings are increasing.

Next post: Analysis of Swiber's 2Q 2007 Financial Results + Updates for Boustead and Global Voice....stay tuned !