Warren Buffett v. Dividends

The difference between Warren Buffett and the man in the street is that he buys the whole company and not just a few shares! If he doesn't buy the whole company he buys sufficient to get a seat on the board. He has control (or at least influence) over the dividend policy of the company, and can distribute the entire earnings of the company if he so chooses; so his view of Free Cash Flow is different to yours and mine. We have to be content with the dividend policy of the company and the integrity of directors - that they will not change the dividend policy unless in the interest of stockholders.

We should therefore base our valuation of a stock on the expected flow of dividends over the investment period plus the expected proceeds from sale of the investment at the end of the period.

You can Fake Earnings

Existing earnings-based models are based on company-declared earnings. Any reader of the financial pages over the last few years should be able to cite a string of reported cases where listed companies over-stated earnings and/or disguised debt levels through off-balance-sheet structures.

Even when adhered to, accounting standards allow a fair degree of latitude in how companies report earnings. The standards themselves are the result of a political process, rather than a purely academic exercise as to what method most accurately reflects performance and financial position. Reported earnings also do not reflect available cash flow, especially with growing companies. Accounting profits may be tied up in additional fixed assets and working capital required to support new sales.

Management are constantly under pressure to deliver results. If they fail, they often attempt to hide this from stockholders. When a company fails, stockholders are often the last to know.

But you can't Fake Dividends

Dividends are paid in hard cash. They reflect a company's ability to generate free cash flow and cannot be disguised or manipulated. Whatever accounting earnings may state, if there is no cash in the bank account, the company cannot pay dividends. Also, if debt servicing cost strain company resources, there is unlikely to be sufficient cash for dividends.

Dividends also reflect the integrity of management. If cash available for distribution is retained by the company, stockholders are entitled to a full explanation; not just empty rhetoric about "new opportunities". Remember the old proverb: "A bird in the hand is worth two in the bush".

Companies that do not Distribute Dividends

Where a company does not issue dividends - all we need to calculate is the expected exit price at the end of the investment period.

We need to recognize a few basics first:

• An operating company that will never pay dividends* to shareholders is worth zero.
• The only reason that a stock has value is the expectation of future dividends*.
• Growth stocks that do not distribute dividends only have value because shareholders expect them to be able to pay dividends* in the future.
• The longer the time period before shareholders can expect to receive dividends*, the greater the risk.

* I use the term "dividend" loosely to include any distribution that delivers cash to shareholders: Share buy-backs and distributions of cash or saleable assets on the break-up of a company are two other forms of distribution that achieve the same end.

Question & Answer

Question: A reader asked how the above model would apply to Berkshire Hathaway, Warren Buffett's holding company, which has enjoyed enormous appreciation over many years while never distributing a dividend.

Answer: Berkshire Hathaway is an investment fund, not an operating company. Its value should be based on the breakup value of the underlying businesses plus market value of securities and cash. According to Richard Band, in 2004 Berkshire Hathaway (BRKA_NY) traded at about a 40% discount to net asset value.

The Dividend Approach

There are three variables that affect the cash flow:

• Expected dividends in the next year;
• Expected future growth in dividends;
• Expected sale value at the end of the investment period.

And three variables that affect the value of the investment:

• The rate of return expected on risk-free investments such as government bonds;
• Our tax position, which determines our net cash return from the investment; and
• The margin of safety required to ensure that we achieve our minimum rate of return.

Cash Flow

Expected Dividends in the Next Year

The simplest method is to use an analyst's forecast, of which there are many available. Find a reliable analyst or use consensus earnings forecasts.

Only create your own forecast if you have time and the necessary expertise.

Expected Future Growth in Dividends

This is the critical question: At what rate are earnings (and dividends) likely to grow over the (long-term) investment period? The expected rate of growth is the biggest single determinant of a stock's value. Unfortunately no one can predict earnings growth with certainty, there are too many unknowns lying in wait for us.

We have to make our best estimate, considering the major risk factors. See Value Investing for more detail.

Expected Sale Value at the End of the Investment Period

The expected sale value (or terminal value) at the end of the investment period is calculated using two variables:

• the expected dividends at the date of sale; and
• the expected dividend yield on which the stock will be sold.

The expected dividend in the next year is calculated by compounding current dividends by the projected growth rate.

The expected future dividend yield should be similar to the existing yield - unless current market conditions are unusual, or the future growth rate is expected to decline over time. It is normally best to adopt a conservative approach and use a higher future dividend yield.

Risk-free Rate of Return

The risk-free rate is the yield on long-term, risk-free investments such as government bonds, in a normal market.

Take a look at the yield on 10 year bonds over the last decade and decide what the expected rate of return will be in a normal market. Consider whether there is likely to be any future change in the long-term rate of inflation.

Inflation and future interest rate expectations should already be factored into current bond yields, but remember that bond markets tend to over-react to good and bad news, similarly to stocks.

Tax Position

Your tax position affects the net return that you receive on your investments. There are three major influences:

Marginal Tax Rate

You need to estimate your average marginal tax rate over the life of the investment. Your marginal tax rate is the rate of tax you will pay on an extra dollar of income (ie. the top rate of tax that you pay). It is often safest to assume that your average marginal rate is equal to the top tax rate, but it could be as low as zero.

Franking Credits

Franking credits allow taxpayers to offset tax paid by the company against their personal tax liability. Some countries do not recognize franking credits.

Franking credits on dividends will be influenced by two factors:

• Will the company be in a position to distribute fully-franked dividends? This depends on the amount of foreign income and the level of tax paid on local income.
• What is the likely company tax rate over the investment period?

If no franking credits are available, then the rate is equivalent to zero percent.

Capital Gains Tax

Some countries tax investors on capital gains. Capital gains in some countries are fully taxed but at a lower rate, while other countries tax only a portion of capital gains (Australia taxes 50% of capital gains) but at normal marginal rates of tax.

Note

In some countries and circumstances capital losses may be offset against present or future capital gains.

Margin of Safety

Benjamin Graham believed that you should first focus on the security of your investment: ensure that you get your capital back plus the rate of return paid on equivalent risk-free investments.

The return on stocks is highly variable, so there should be a margin of safety: you may expect the company to grow earnings at a rate of 20 per cent per year but what if the growth rate falls to 2 per cent? Are you still going to achieve your required minimum rate of return?

Consider the risk factors: the larger the business risk, the larger the required margin of safety.

A rule of thumb I use for "cash cows" (mature companies with a reasonable dividend policy):
Discount the expected dividend flow for the investment period (normally 15 or 20 years) using a risk-free rate of return. If the present value of expected dividends exceeds the current market price then we normally have a healthy margin of safety - the proceeds from the eventual sale of the investment.