Wednesday, June 11, 2008

* Dividends - The Capitalist’s Ideal

Below is a guest post by Sarah Scrafford.

Corporate ownership and private enterprise have been the buzzwords of developed economies for quite some time. Privatization has been a positive trigger for rallying stock markets all over the world. It was the sign that heralded the readiness of a corporate entity to meet the harsh and demanding needs of the private investor. But what makes a public company a headline stealer? It’s either the fact that the company has made castles in the air real for a multitude or, at the other end of the spectrum, because it has shattered the dreams of millions.

What is the factor that people use to differentiate between one good “investor-friendly” company and another? Great investors have long known that the only real sign of a great company or business is the amount of cash it can generate year after year. For the common investor, a rough estimate of this is the cash dividends that he/she receives on account of owning company stock - the higher the dividend, higher the return on his investment. But what makes a good company a great one?

Let’s look at two famous ones - GE and AT&T. Both companies have maintained the enviable and stellar record of never having missed a year in paying dividends. The icing on the cake for the investors in these two enterprises is that the dividends have been on the upward trend, continuously increasing from start to now. But the difference between these two and other companies lies not in the amount of dividends paid, but in the “Dividend Decision” itself.

The big question is - how much of the company’s cash earnings should be distributed as dividends? AT&T has always paid out more than 60 percent of its per share earnings and GE has sent out at least 35 percent year after year. Now the question arises - why don’t other companies follow the path that these two have chosen?

Classic theories state that the dividend decision taken by the Board of Directors takes into account all investment opportunities and then allocates capital to a place where it will hopefully earn a better return than it would if it were paid out as dividends. In simpler terms, it means that the company will pay out dividends only if it cannot find a new project or opportunity which would offer higher returns than cash invested elsewhere.

GE as a corporation operates in an industry where innovation can bring about or create a brilliant new chance to rake in the dollars. While AT&T pays out more because, in an aging industry where growth rates are nearing lower single digits, it cannot invest the money it generates to deliver better returns, GE can afford to retain its earnings and invest so that the pace of creating shareholder value is higher than the average alternative.

Coke and Warren Buffett have been in a similar marriage since 1988. Coke has an excellent record, just like GE and AT&T. But why did Buffet make more money than everyone else? In 1988, he bought Coke at an average of $4.75 per share. Today, the cash dividends alone amount to $1.52 per share. That's a cash return of 32 percent every year. And as long as Coke increases its dividend payout, Buffett only becomes richer and richer, at an increased pace.

To put it in a nutshell, if the stock markets didn’t exist, the only way an investor could earn from an investment is through dividends. It has thus become of utmost importance to find save haven in dividend-paying companies during the markets’ troubled times.

Sarah Scrafford is an industry critic, as well as a regular contributor on the subject of entrepreneurial finance. She invites your questions, comments and freelancing job inquiries at her email address: