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.

The Basics

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. Profits paid out as dividends earn investors a rate of return equal to the “earnings yield” of the stock. That is the same as the flip of the P/E multiple, or the ROE divided by the Price/Book multiple.
3. This return is usually far lower than the return earned by reinvesting in the business. (Depending on the incremental ROE).
4. Dividends reflects a lack of better business opportunities, or a preference by management for a certain type of investor.
5. Management compensation that depends on capital appreciation may isolate 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. That provision rarely exists for securities issued into the market.
6. Dividends can be used to hide management compensation, because they are recorded below the Net Income line. Shares are issued to management for debt. Distributions paid on those shares 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 proof and explaination.
7. 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.
8. Dividends can be used to hide interest expense. See the discussion below under “Financing with Equity”.

Share BuyBacks

1. Share buybacks are equivalent to the receipt of dividends. Investors’ rate of return will be the same as for dividends – the earnings yield.
2. 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.
3. 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.
4. 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 eventually exercised, the shares are reissued with no dollar value change, or change to the gross number of shares outstanding, in Shareholders’ Equity. In reality this does not change the opportunity cost of options. They should be measured separately. See the details at Comprehensive Earnings
5. 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.
6. Since buybacks are equivalent to dividends it is reasonable to conclude that valuation metrics based on the present value of future dividends should include buybacks as well. But it has been argued that this can result in double counting cash. The cash use for buybacks reduces cash available for future growth in total dividends. The reduction in the number of shares on which dividends are paid, is offset by the reduced cash available for dividends. 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 which issues more shares.
2. This is equivalent to reinvesting profits… but inefficient due to costs.
3. It is not equivalent to receiving cash dividends to be deployed in the secondary market because the cash is retained in the primary market where its returns are higher.
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 below.
2. If 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 Earnings.
4. Issuing shares does not dilute existing owners because $ proceeds are received in exchange. 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.
5. If sold for less than “book value per share”, all shares will have fewer assets working to earn income. 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.
6. If sold for more than “book value per share”, the premium will be shared by all shareholders. Each share will have more assets working to earn income. EPS will be expected to increase. The increase should not be interpreted as “due to good management”. It is a result of the secondary market for shares, not management actions.

Financing with Equity

1. 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 indicates the existance of financing with company shares. The company may sell shares into the market, hoping to buy them back later at a lower price. But more probably there is an agreement with a bank. The shares are sold to the bank for cash, and the agreed repurchase price includes interest on the cash. Any dividends issued during the period would reduce interest added to the repurchase price.

STOCK OPTIONS, DILUTION & BUY-BACKS

Stock options

• defer income tax for management.
• are taxed at half the rate of wages. The company loses half their tax deduction.
• 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 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 are: A) The Core Business. Most businesses earn a return on assets (ROA) in the 10-15% range. Reinvesting the earnings of the previous year 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 ROA.C) Reduce Debt. Most companies use debt to leverage the ROA into a higher return on equity (ROE) for shareholders. Reducing the debt will lower the company’s risk, but will also impact the ROE. You need to compare the hurdle interest rate (%) to the ROA(%) to see if debt is good or bad. 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 redeploying 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 redeploy 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 expecially true if the business bought was publicly traded at a multiple of book value (say 2 times). The purchaser faces the same math as the diagram above. Since they usually have to pay a premium to market value for control, their incremental return on the cost will be LESS than half their pre-existing ROE.

When the business purchased is private, and the purchase is paid for with shares that trade at healthy multiples, the probablilities 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 the discussion (items 2, 6 and 7) on how to integrate these numbers into Comprehensive Earnings Per Share.

Yes, when the same earnings are shared between a greater number of shareholders, each will receive less. 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 pre-existing owner should be indifferent. He will be in the same position as if he had sold that same % of his shares in the market.

To determine whether you have a capital gain or loss, compare the issue price to the book value of the existing shares. A greater price : you gain. A lower price : you lose. A company will likely be in distress if it resorts to issuing new shares at a price lower than the existing book value. When the issue price is between the book value and the market price (e.g. options compensation), you realize a gain, but not the full gain you are entitled to. It is as if the company had forced you to sell, to a friend of theirs, a % of your position at a price below the market price.

The following example follows what happens when new shares are issued, 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.

1. You start a business with $10,000 capital and 1,000 shares.
2. The company grows to be worth twice as much: $20,000. From your position now follow the two scenarios.
3. A new 50/50 partner pays $20,000 for 1,000 new shares.
4. The company doesn’t need the cash so it pays $20,000 out as a dividend.

• The company is not changed. 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.
• You
  1. Seeded capital = $10,000
  2. Received dividend = $10,000 (half $20,000) which left you 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 your shares in the secondary market. For 500 shares the buyer would pay $10,000, giving you a realized capital gain of $5,000 on half your holdings. That leaves you the same cash cost = $0 as the first scenario, and you 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 a previous webpage.

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. There are always equal parties on both sides of an option contract. The exchanges make sure of this matching for public trading. That is why they ask if your order is ‘opening’ a contract or ‘closing’ a pre-existing one. The company cannot get rid of its options liability without either paying someone to assume it, or settling it. While there are third-party outfits who will offload the option liability from the company, the vast majority of compensation options are settled by the company who issued them. At no time does ‘the market’ assume the liability, especially not for free.

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. Options are a zero-sum game: one person’s gain is another person’s loss. When management benefits from the options someone must lose. That someone is the business.

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 that is managed by its owners. 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. If you don’t understand this without a ‘market value’ for the firm, pretend the company is up for sale during the issue of the options.

3. The full cost of options compensation cannot be known at the time of their issue. The closing transaction to settle the contract depends on the market value on that later date. The cost/benefit of all options is not know for sure until then.

What is recorded by management is only the value of the premium you would demand in the market if you sold (to open) a call option on the company. While the value of this premium would change as the stock price changes in the open market, management does not adjust the value of their recorded liability. This violates the basic concept of the Balance Sheet which is supposed to measure the value of the assets/liabilities AT THAT POINT IN TIME.

Eventually the contract expires, with its premium equal to the intrinsic value of the option. This should be the final adjustment to the total cost recorded by the company. This is what you would record in your personal records if you sold an option yourself. There is no difference.

………………………….

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 (before options expense) decrease …. 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

Shareholders are drained by the cost of options exercised, not the options outstanding. A company with (say) 5% dilution from options outstanding, may in fact be exercising those 5% each and ever year, and reissuing new ones. In five years management will own 25% of the company. The cost of the options is not 5% of the earnings each year. The cost each year is 5% of the value of the company.

As an analogy, consider a Canadian’s portfolio of US stocks in a year when the exchange rate of the dollar decreases 20% (lets say permanently). While it is true that the future income from those stock will be reduced 20% by the new FX rate, what really needs to be measured is the loss in value of the portfolio itself. The loss is 20% of the portfolio’s value. It is this reduced value of the portfolio that creates the 20% reduction of future income.

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.

‘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.

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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 would disappear if options were measured correctly?” 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 (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 to $22.0.
• The options value will now be (22-20=) $2.00.
• That liability ‘per total #shares’ is (5/105*$2.00=) $0.0952/share.
• Compare the increase in liability (which was not booked as an expense) to the increase in earnings = (.0952/0.10=) 95%

………………………….

But EPS DOES increase when companies use options !!! Yes, but that does not make this metric wrong.

1. The EPS increase is due to the issue of new shares at a market value greater than the existing shares’ book value. We see this in (B) below.
2. Reported earnings do not includes the cost of your lost %ownership in the company. In (C) below we see the unmeasured $200 cost of options equals the anticipated $200 growth in earning predicted in (A).

Compare what happens to a company when:
A) it has no equity transactions, vs
B) new shares are issued into the market, vs
C) the shares are issued on the exercise of options, vs
D) all the share dilution of options is reversed with share buybacks.

(A) The basic company with lack-luster management starts with:

• book value of the company assets = $5,000
• # shares outstanding = 1,000
• expected ROE = 20% = expected growth rate
• earnings expected = $5,000 * 20% = $1,000 or $1/sh
• stock price = $20 giving a P/E=20

The business uses no options and reinvests is earnings at the same 20% ROE rate. The earnings increase 20% and the stock price can be expected to increase 20% as well to $24/sh.

(B) The same business issues 5% new shares at the end of Year1. The excess premium over book value benefits all the shareholders $0.857 [=($24-$6)*50/1050sh]. Think of the $0.857 as the capital gain that would have been realized if the owners sold the same % of their shares in the market. Since the gain stays in the company, owners benefit from the increase in future earnings on the gain.

(C) Below, the business issues 5% more shares as options at beginning of Year1 in order to attract superior managment. They have a strike price equal to market value ( $20 ). All were exercised at the end of Year1 for $1,000 ( = 50sh * $20 ). So the assets received by the company are $200 less than if issued to the public at market value. The economic cost of options equals their intrinsic value: 50sh * ($24-$20) = $200. The published earnings do not include that $200 loss although it is very real.

This cost is precticted by the formula presented above that answers the question: “What percent of earnings growth goes to options holders?:
(% options dilution) * (P/E ratio):
50/1050 dilution * 20 P/E
equals 95% of $0.20 earnings growth (= $0.19) went to options holders.

(D) In this scenario, the company buys back from the market all the shares that were issued on exercise of options. In order to isolate the effects of options, you must remove all the benefits (see (B)) of share issues. The result is a company with $200 less assets than was seen in the basic scenario (A). Remember the excuse for options is to promote superior management and the generation of superior returns. Yet this shows that the rewards go to management, not the owners. The owners are worse off from the excercise.

(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 Cash Truths. Also, when management knows that distributions will be recyled back into the company via DRIPs (dividend reinvestment plans), they can distribute more than what is sustainable, giving the appearance only of liquidity.

(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 two arguments supporting the preference for dividends, both of which are wrong. The first claims that “dividends account for 97% of investor returns” is discussed below.

(v) A second argument is that inflation eats into growth, making the dividend an even greater portion of your total return. The speaker starts with equity’s real-return, the return after inflation is subtracted. He subtracts from this the dividend yield to arrive at the supposed real-return from growth. That argument is wrong because inflation eats into all returns, whether paid as dividends or realized as capital gains. Inflation reduces the value of a dividend just like it reduces the value of a bond’s interest coupon. 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.

(vi) Investors are skeptical about management’s use of profits retained. They think profits will be wasted on executive jets, etc. In reality companies earn handsome returns on those reinvested dollars. The long-term US average is 13% and the Cdn average is 16%. See the chart of re-investment returns on Sheets 19 and 20.

As the economy moves away from hard-asset-manufacturing toward service industries dependant on people, not assets, returns on assets increases. 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.

It may be that the perception that earnings are not well reinvested comes about because investors are not correctly measuring the earnings in the first place. As discussed elsewhere on this site, reported earnings do not include all the foreign exchange costs, or the cost of stock option compensation, or compensation using dividends, or the cost of buying other people’s businesses (goodwill), or the changing status of pension liabilities, etc, etc.

(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, 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.

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) 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.) This defense of dividends applies only to everyone else.

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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.

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

• Most Canadian testimentary trusts are set up to distribute income to a surviving spouse during his/her lifetime. Than 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, dividends have a greater emotional wallop.
• Healthy dividends prevent some of the games management plays 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. While stronger businesses might use the opportunity to purchase weaker competitors with retained earnings, it might also be argued that issuing new shares for the expansion is better. Even though the share price will have fallen, as long as it is greater than book value, the benefits from new shares is huge and mostly unnoticed by investors. The double punch of a stronger share price (supported by dividends) and the un-measured capital gains from issuing shares might be unbeatable.
• 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 compensate the owners from whom they borrowed for all dividends. 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 following three sections all deal with variations on a similar theme – a dividend yield calculation that leads long-term holders of a stock to believe they earn a higher yield than new purchasers. Investors with strong feelings that dividends are the best form of return are very resistant to learning that their calculations are a delusion. They claim that their metric is correct because they disclose the calculation and their math is correct. They do not understand that the result is meaningless. An analogy would be the person who recalibrates his bathroom scales below zero, then brags about his weight loss, and truely believes he has lost more weight than you. His conviction holds even as he discloses his recalibration.

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This first error is most common. The investor calculates his personal dividend yield by dividing the expected future year’s dividends by his historical purchase price of the stock. He admits the different denominator and sometimes call it a ‘yield on cost’. He truely believes this metric shows he earns a higher return than someone just buying the stock. He truely believes this metric shows that ‘buy-and-hold’ results in better returns.

Example: You bought bank shares ten years ago: cost = $15.50. Now the shares = $58.00 and dividend = $1.96. Do you consider your yield to be calculated

• on the original cost of the share as $1.96 / $15.50 = 12.6%
• or on the current share price as $1.96 / $58.00 = 3.4% ?

The correct answer is 3.4%. Pretend your broker made a mistake and sold your shares today, only to catch the mistake and reverse the transaction. You might never 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 $1.96.

But now your cost is $58.00 and by your own calculation your dividend yield is 3.4% – even though there has been NO economic change in your ownership since you thought you were earning 12.6%. If you never learn of the transaction you may continue to brag about that 12.6% yield – your own personal delusion.

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When a company’s prospects change and the stock should be sold, this misunderstanding results in a typical error. The owner says “Oh, I can’t sell my stock NOW. I’m making a 12.6% yield and I couldn’t match that with anything else”. 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.

Sometimes investors should, for tax purposes, sell stock to trigger taxable income and reset their ACB higher. This allows them to make full use of the graduated tax rates when they expect their future income to be taxed at higher rates. Investors’ attachment to the yield-on-cost metric prevents them from doing this. They mistakenly think that this high metric means their returns are ‘higher’ or ‘better’. They think that they will somehow ‘lose’ returns if they reset the purchase cost.

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When advisors and the media sell you on the benefits of dividends, they dismiss the value of capital gains. They quote only this wondrous 12.6% yield and attribute the total return to only the dividends (and their growth). The truth is the opposite. Companies can only increase dividends sustainably by increasing their earnings. Higher earnings increases the stock price, as well as allowing the dividend to increase. The resulting dollar amount of capital gains will overshadow the dollar amount of dividend returns.

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Sometimes the metric (Div/Cost) is defended by claiming it allows for comparison between equity and 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 $1000, has increased its dividend from $20 (2% yield) to $60 giving me a 6% yield-on-cost. See how superior dividends are.”

This argument is false. The metric (div/cost) ignores the actual payments over the period in question. It implies that the “6%” was paid every year (just like the debt’s 4%). But if the increase to $60 happened only in the last year, you would come to the wrong conclusion when using this metric. The debt would have been the better investment. 10 years of 4% is greater than (9 years of 2%) plus (1 year of 6%).

There is only one way to compare investments with different cash flows – like debt vs equity. You calculate their total return (income plus capital gains). Investment returns come together in a package. Each dollar of dividend causes an immediated dollar drop in the share price. You cannot isolate one part of the return and conclude from it that one investment is better than another.

A third problem with using this metric when comparing to debt comes from its failure to normalize for risk. Most investors require an additional 3-4% annual return for the additional risk of equity. But no one using the yield-on-cost metric ever makes this adjustment. They must be presuming that the risk differential should be applied against only the capital gains of equity… a ludicrous assumption… especially since those same people downplay the very existence of capital gains.

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Sometimes the metric (Div/Cost) is defended by claiming “sure, it doesn’t measure the yield (at a point in time), but it measures the rate of return (over a year’s time) attributable to the dividend”. This argument does not hold up. Any measure of income is based on the principle dollars invested. When calculating a yearly return, the value of the investment at the beginning of the year is used, not some historical value.

To prove the point use a “discounted cash flow model” (DCF) example. Assume a stock pays a growing dividend equal to 10% of beginning of year price, and the stock doubles in value each year. You can generate a net present value = $0 only by discounting each cash flow using a 110% discount rate (PV of a dollar calc). Each and every year the investment earned a 110% return: 100% capital gain plus a 10% dividend. At no time did the dividend generate a 20% return, or a 40% return (based on original cost).

This is the boast of people like those above, but who reinvest all the dividends in purchasing more shares. Over ten years the reinvested dividends would have bought 35% more shares. The dividends received from all the shares would now be ($1.96/share * 1.35 shares =) $2.65.

They claim a yield based on the historical cost of only the original shares = (2.65 / 15.5) = 17.1%. The error of logic starts with the same error as above, but gets compounded by the subsequent purchases of shares, to which they wrongly allocate $0 cost. The proof that the true yield is still 3.4% is the same as above: sneak in and sell/repurchase their shares.

See also the discussion on keeping track of the ACB cost of your shares.

A variation on the errors above is the person who considers the latest dividend to be income … but all past dividends were reductions of his cost base. The yield he calculates is based on this much reduced cost base – so overstating it. But you can’t have it both ways: either the payment is income or it is a reduction of your cost base. It cannot be both. And it cannot be changed ‘after the fact’. A normal dividend is income in the year received and does not become a return of capital after a year.

Income trust distributions labeled a return of capital (ROC) are a different story. These are distribution in excess of earnings and reduce the cost base. They should never be consided income or included in the numerator of any yield calculation. See also the discussion of ROC.

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. For the S&P500 index over 81 years to 2007 the difference between

• the total return index average growth = 10.2%, and
• the index’s growth without reinvesting dividends = 6%
• equals the average dividend return = 4.2%.

So the portion of the total return from dividends was ( 4.2% divided into 10.2% =) 41%. But even that cannot be considered true today. Over the last 19 years dividends averaged 2.5% while total returns averaged 12.2%. So the dividend component of total returns was only ( 2.5% / 12.2% =) 20%. See the first page of this spreadsheet.

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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.

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The original claim is being mis-quoted. It did NOT say “97% of your returns”. It said “97% of accumulation”. The 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 resulting portfolio value of $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 the 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 was NOT talking about 97% of the rate of return. He was talking about 97% of the resulting portfolio value.

Be clear that reinvesting ALL profits is important for asset accumulation and portfolio growth. In fact using the exact same math it can be shown that reinvested capital gains account for 99% of the accumulated portfolio. Since capital gains are a larger portion of the total return, it would be expected that without reinvesting them the portfolio would be smaller even than when dividends were not reinvested. The data can be checked on the second page of this spreadsheet.

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Neither Graph Measures The Income Split Between Dividends and Capital Gains.

What is being measured by the two areas of Siegel’s graph? Look at Box (C) in the spreadsheet. What Seigel labelled 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 the calculation used.

The top line of Siegel’s graph is really the sum of the values of two different portfolios. The graph’s bottom area measures a portfolio where all your money starts (P1). Each year P1’s dividend income is removed and used to fund a second portfolio (P2). The middle area of the graph measures the size of portfolio P2.

• Both portfolios are invested in exactly the same securities. This has two implications.
  1. The income of both portfolios comes from a blend of dividends and capital gains. So even though P2 is funded by only dividends it grows from capital gains. This contamination destroys its ‘dividend purity’.
  2. The growth rate of each will start off being equal. (Using a log scale the slope of the lines are the same.)
• Taking dividends out of P1 will reduce its rate of growth in size (but not its yearly rate of return). The asset transfers to P2 will increase P2’s rate of growth. P2 will grow faster – no matter how small the dollars transferred – no matter if they come from dividends or capital gains – no matter how large the original principal in P1. Because P2’s slope (rate of growth on a log scale) is now steeper, it will eventually account for 99.9% of the combined portfolios value – by definition. Whoever grows faster wins. It is the transfer of assets that creates the difference, not whether the assets are dividends or capital gains.
• The amount of P1’s dividends, earned and transferred, increases over time, as P1 grows in value. P1 grows in value because of ONLY capital gains. The increase in dividends transferred is attributable to the wonders of capital gains, not dividends.

So How Do You Graph The Contributions From Dividends And Capital Gains?.

There does not seem to be any way. All have problems with contamination.

Conclusion

You must be aware that even academics can be full of hot air. Siegel’s graph measures nothing of value, and proves nothing. Even retail investors can smell a rat when they read the nonsensical statements like the following from ref:”Optimists”, based on the same fallacy. “While year-to-year performance is driven by capital appreciation, long-term returns are heavily influenced by reinvested dividends”. 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.

The same “Optimists” uses this fallacious analysis to conclude the Dividend Discount Model is the most important for valuing stocks. They say dividend models are supreme because “capital appreciation dwindles greatly in significance [over time].” Garbage.