To pay dividends, or not?

Press, 29 August 1977, Page 22

To pay dividends, or not?

By

ADRIAN BROKKING,

Commercial editor

Last week we established that a company could pay out the whole of its profit in dividends, and raise the equivalent of the amount of earnings normally retained by way of share issues. We also looked at the mechanics of share issues, and noted that the effect — at least as far as the arithmetic of the exercise is concerned — was the same if the retained earnings were paid out in bonus shares.

In practice, there are considerable differences. The first one to look at is the tax-angle Dividends are taxable; so are bonus issues by way of dividend. Therefore, to take up the annual rights issues in Table 2, the shareholder has to find the

tax element out of other i 'savings. It would be thel same for annual bonus H i issues. , Of course, this is the nor-1 mal situation for any in-1 ; vestor who is increasing his ' investments. He has to pay!, tax. and find the money for ' i the additional investments | out of his disposable income. < But he is not obliged to go on investing more and more, i while in our second example : we assume that he does. In contrast, retained earn;ings are not taxed. In the 'present climate, where most ; companies retain a high proi portion of earnings, it there- • Tore follows that investing i lin shares contains a built-in ’ element of contractual sav- ' ings. Your aliquot share in i the assets of the company i increases in the proportion 1 that these assets are added I to. Il

This is probably the strongest case for retained earnings — even if the directors are not necessarily using the funds to best advantage, because of empire building, Parkinson’s Law, and all that. The arguments that may ibe brought against the other lease are of two kinds. i First of all, if the company is to pay out the whole of its profit, then the profit figure had better be right. Just in case you are raising your eyebrows, let me explain — and I will expand on this in later articles — that there are as many “true and fair” views of what a particular profit figure should be as there are accountants. Within reason,

the profit declared by a com-, pany is what the directors I say it is. A typical example would: be depreciation. Say company A buys 10 tour coaches at $120,000 each. The company reckons that they will last 10 years. Therefore it writes off $120,000 a year. Now company B, next door and operating on basically the same routes, says that its coaches will last 12 years. It writes off $lOO,OOO a year, and its profit looks better by $20,000. Now the argument of those that are against high , payouts is that if the comjpany makes a mistake and later on finds that it needs more funds for asset-replace-ment, it has ‘dissipated’ the funds by paying them to shareholders. “Dissipate” is their word, not mine.

Another snag is the risk of dividend fluctuations, because profits rarely keep increasing at a steady rate. In

our example we have assumed steady earnings, but profit ratios do fall, and there is no doubt that shareholders do not relish dividend reductions. A further argument of the antis is that the shareholders would only squander high dividend payments, when the company could use the money so much better. It cannot have escaped your notice that the protagonists fall into two cafrips: those that believe that directors know all and shareholders nought, and those that believe that shareholders are quite capable of looking after their own affairs. I, I am on the side of democracy. I cannot see that there is anything wrong with the idea that investors should have a say in the disposition of their own money, or that directors should justify

their expansion plans and the company’s need for more money. But perhaps I am all wrong. Let us try and see what the market — that is all investors — think of the idea. And this is where we go to our tables. The average yield of the 41 market leaders published on this page (and every Monday) is at the moment 8 per cent. This is the highest figure I have records of, and therefore the market is at its lowest level ever. For as -he prices fall, yields increase, and vice versa. Everything else being equal, a low yield implies a high price, and a high yield a low price. Now I know that in money terms the market has been lower on many occa-

sions. But dividends have increased over the years — so has inflation. In terms of yield, the market is very low.

At previous peaks (new high levels of share prices) yields have always been around 4 per cent. At previous lows they have been around 6 per cent. Therefore, up to about two years ago, you might have been forgiven for thinking that the long-term average yield of shares was around 5 per cent. The average dividend cover of our 41 market leaders is about 2.5, and the average price-earnings ratio is 5.

At the last market peak, in July 1973 when the index was 405, the average dividend yield was 4.1 per cent, and the average priceearnings ratio of 4, I am very Therefore, if in our first example, I assume a priceearnings ratio of 4,1 am very conservative, and the share_

price of 160 c is very conser-. vative. Don’t forget, we have I here a company with a good earnings record, which has! announced that it is going to retain a high proportion of earnings so as to increase i future profits. The only further assumption I have made regarding! our first case is that — after, the understandable initial! scepticism — the confidence of shareholders increases asi profits increase, and that! ! after six years the P/E ratio will rise to 10, giving a share price of 795 c. In our second example 1 have worked from the other end: I assume an even greater scepticism on the part of shareholders that high dividends may not be maintained — for some of the reasons discussed above — and therefore that even after the first high dividend payout the shareholders insist on a dividend yield of 12 per cent — a buffer as it were.

But as the company lives up to its promise, again shareholder confidence will increase, and the dividend yield comes down to 6 per cent — this is still a high figure. ! After ail, if the market ac- ! cepts the validity of the first 40 per cent dividend, and it ! discounts that to a market : yield of 8 per cent, the price ! of the share would be 500 c : in the very first year. ! If we accept this reasoning, then you finish up in our ‘ I first example with one share I worth 795 c (say five times • your original investment) and ' in our second example with ■ virtually two shares worth I 1333 c (667 c each) being about s four times your money. In the first example the i company could split the . shares (i.e. make a bonus , issue) one for one, but that i would only halve the value r of the shares, so that sharei holders would be no better > off. Besides, retained earnings ■ are revenue reserve, and tax

would have to be paid. In the second example the shareholders’ funds would include a substantial amount of share premiums, and therefore a bonus issue could be made even though there are more shares outstanding. But again you would not get anything you had not already got. Obviously, from a theoretical point of view, there is little between our two examples. Much depends on the correctness of the assumptions even where these have been tested against markets in a parallel way. We could only find out which investors preferred in an empirical way.

The immediate gut feeling of anyone in touch with the market is that dividends do matter, or at least that they matter in New Zealand. Next week therefore, we shall examine the records, to see if there is any wisdom to be found in those.

Year 1 2 3 4 5 6 Capita] .. M M M M M M M Sh. funds .. 2500 2775 3094 3464 3893 4391 4969 Profit 400 444 495 554 623 703 795 Dividend 125 125* 125 125 125 125 125 Retained 275 319 370 429 498 578 670 P/E Ratio 4 5 6 7 8 9 10 Share price .. 160c 222c 297c 388c 498c 633c 795c Asset back .. 250c 278c 309c 346c 389c 439c 509c

Year ... 1 2 3 4 5 6 7 Capital .. 1000 1110 1237.5 1385 1557.5 1757.5 1987.5 Sh. funds .. 2500 2775 3094 3464 3893 4391 4969 Profit 400 444 495 554 623 703 795 Dividend 400 444 495 554 623 703 795 Retained — —— —— — — — —- P/E Ratio 8.3 9.0 10.0 11.1 12.5 14.3 16.7 Share price .. 333c 364c 400c 444c 500c 571c' 667c Asset back .. 250c 278c 309c 346c 389c 439c 509c Div. yield .. 12p.c. 11 p.c. 10 p.c. 9 p.c. 8 p.c. 7 p.c. 6 p.c.