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Paying dividends vs paying off debt vs using deposits

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February 06, 2012 – Comments (14) | RELATED TICKERS: JPM , BAC , C

So, none of this is going to be rhetorical, just a few questions.

Is it responsible for a company to pay a dividend when they still have debt?  If the interest rate is say 9%, why pay a dividend?  Thats a higher rate than the average investor will be able to get if he reinvests the dividend somewhere else, so isn't it bad for stockholders to take a dividend when the company could be using that money to pay off the debt and increase earnings?  If the interest rate is low, say 3%, I guess that is a different story but surely the company can earn a higher than 3% return themselves and should probably just reinvest in the company.  But my question is mostly for debt above 4% or so.

 

On a semi-related topic, why do any banks sell corporate debt when they can't even lend all of their deposits?  Banks are having a hard time lending the excess capital they have, so why would any bank ever need to sell corporate debt for 4-5% when they are already taking in deposits at 0.2% and can't put it to good use?

14 Comments – Post Your Own

#1) On February 06, 2012 at 11:34 AM, SkepticalOx (99.42) wrote:

I thought this explanation was interesting:

Agency theory assumes that large-scale retention of earnings encourages behavior by managers that does not maximize shareholder value. Dividends, then, are a valuable financial tool for these firms because they help avoid asset/capital structures that give managers wide discretion to make value-reducing investments. The evidence presented in this paper uniformly and strongly supports this view of dividend policy. 

The rest of the NBER paper is here. Essentially, debt focuses management and having too much cash on hand just allows them to run amuck. The paper also argues that if dividends were not paid, most of these dividend paying firms would have huge cash balances and would've paid off most of their debt. 

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#2) On February 07, 2012 at 12:10 AM, Valyooo (99.34) wrote:

That's interesting...but they can use it to further the growth of the company if they had too much cash on hand after debt is paid off.  But it is very interesting.

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#3) On February 07, 2012 at 12:16 AM, truthisntstupid (80.81) wrote:

     "Many corporations that consistently show good returns both on equity and on overall incremental have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis.  Their marvelous core business, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics).   The managers at fault periodically report on the lessons they have learned from the latest disappointment.   Then they usually seek out further lessons.  (Failure seems to go to their heads.)

     "In such cases, shareholders would be far better off if earnings were retained only to expand the high return business, with the balance paid in dividends or to repurchase stock (an action that increases the owner's interest in the exceptional business while sparing them participation in subpar businesses).   Managers of high return businesses who consistently employ much of the cash thrown off by those businesses on other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.

     "Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities.  Shareholders of public corporations understandably prefer that dividends be consistent and predictable.   Payments, therefore, should reflect long-term expectations for both earnings and return on incremental capital.   Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often.    But over time distributable earnings that have been withheld by managers should earn their keep.   If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained."

-Warren Buffet

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#4) On February 07, 2012 at 12:48 AM, truthisntstupid (80.81) wrote:

Sorry about the boldface. I copied it from another post, and I didn't know how to remove the boldface without re-typing it. Anyway, that's part of the reason all cash can't be reinvested in a business to "force" more growth.

 (1 - Payout Ratio) X Return On Equity = Sustainable Growth Rate.

A dividend drops the sustainable growth rate figure, but usually not enough. After the dividend, the rate we're left with is often still too high to be attainable as a realistic rate of long-term expansion.

My last CAPS pick, Hasbro, has a return on equity of 28%. Its payout ratio is 39%.

(1 - 39%) X 28%...= 17%.

With only the dividend, the sustainable growth rate formula yields a figure that's still over 17%.

Hasbro is a $4.5B company with 5,800 employees. It is already one of the top two companies in its industry. Using the rule of 72 tells us that Hasbro would have to double in size every 4.2 years if it is to grow at 17% annually.

Obviously that probably won't happen. So if we want to maintain a return on equity of 28%, we need to further reduce the other multiple. By using a combination of dividends and buybacks, we can get that sustainable growth rate down closer to a more realistic figure.

Buybacks can help to bring the sustainable growth rate more down to earth.

Some arguments are made in favor of buybacks only. I think that's a mistake.

I believe that quite often buybacks are ultimately used mainly as devices to funnel "dividends" to high-ranking company execs and board members.

If Hasbro were to retain all its earnings, there's no way it can expect to maintain 28% a year growth selling toys. So its return on equity would have to fall to equal the actual rate of growth it can realistically expect to achieve.

Just in the last five years, Hasbro has returned $520M to shareholders in the form of dividends. It has returned $2,329M to shareholders over the last five years in the form of buybacks. So it has in the last five years alone returned a total of $2,849M to shareholders.

That's just in the last five years. Hasbro has been paying dividends since 1981.

Imagine all the tens of billions you're inferring that Hasbro could have kept to grow the business. They couldn't have reinvested all those billions back into the company and achieved a return that justified them keeping the money...unless you believe that it's possible for Hasbro to have a marketcap of maybe $50B. Keep in mind Hasbro's marketcap is about $4.6b now.

They're at the top of their niche, with Mattel. They just couldn't have put all that mnoney back into the company without wasting it. Their fiduciary responsibility to their shareholder, then, is to share the profits and give them the best return possible on their money while trying to target a realistic rate of growth at a high return on shareholders' equity.

 

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#5) On February 07, 2012 at 11:25 AM, Valyooo (99.34) wrote:

All of that was very helpful and informative, but I feel that it does not answer the question at all.

Even if they cannot grow the core business at a very high rate, why not use the earnings to pay down debt rather than pay dividends if the interest rate is high?  That will cut expenses a lot, and increase earnings more, which will bump the stock higher (and lower future risk, probably expanding the multiple as well) rather than just give the money back?

If you had $10,000 in credit card debt that you were paying 10% on, and you had a line of credit that was charging you 0%, would you use the money from the line of credit to pay off the debt? If so, then I would think you would also pay off debt before distributing dividends.

 

Also, still not sure why banks float debt when they can't even lend their deposits.

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#6) On February 07, 2012 at 12:21 PM, truthisntstupid (80.81) wrote:

I'm sorry, Valy. I completely spaced that. I believe I do have an answer for that, but not right off the top of my head. I'll get back to you in a while after I make an errand run.

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#7) On February 07, 2012 at 12:54 PM, mm5525 (< 20) wrote:

What about simple investor demand? I would never buy a bank stock if I didn't get a dividend. How many others feel the same would be interesting (and impossible) to know. I mean a real dividend, not a penny. I own JPM for that very reason, and the dividend kept me in it through the 40s and through the 20s, and almost back again, fortunately ;).

I would rather a company hold debt, even at higher rates, and have the flexibility to refinance that debt or sell assets than have a mandated rule of no debt under any circumstances before distributing cash to shareholders. I want a slice of the profits without ever having to hit the sell button. It's simply part of why I make the investing decisions I make. No telling how many investors make these same decisions, especially in a low-rate market we have today. It'd be interesting to see an analysis, although I admit it'd be very difficult to analyze, of how much more investor capital goes toward a financial that pays a decent dividend, such as JPM, USB, WFC etc compared to financials such as C or BAC that have to do things like reverse stock splits or get bailed out by Warren Buffett (and sell assets) just to remain afloat. My guess is a moderate, Mendoza-line-or-above dividend shows some sort of financial strength that would attract more capital (and flexibility) than someone who churns out a mere penny. Perception is often the reality, as the stock market is simply a market of stocks. If a financial pays a decent dividend, they are viewed as more solvent than a BAC or C, which would, in my view, attract more money. Just my $0.02... or just my penny, LOL.     

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#8) On February 07, 2012 at 1:31 PM, Valyooo (99.34) wrote:

Truth,

Your comments still were helpful, and you answered my question about why not reinvest in the business, so it's not like you wasted your time.

mm5525,

You have a valid point, but I don't like that strategy long term.  If no dividend was paid, and they used the money to pay down debt, and therefore the P/E was hurt as a response, they could finish paying off the debt, use some money after that to buy back the stock at the cheap price, then pay a dividend a few years down the road and watch the price explode.

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#9) On February 07, 2012 at 2:02 PM, mm5525 (< 20) wrote:

I view it more as the same thing as the struggle whether or not to pay off one's mortgage. I might have the cash to pay off my mortgage, even if it's at a moderately higher rate, but to do so admits "defeat" that my company, in this case my house, can't outperform the interest rate of my debt. Psychologically, it might feel warm and fuzzy, but it does limit my flexibility. What if the day after I pay off my mortgage I'm presented with a great opportunity for growth? Suddenly I can't, or I'd have to rely on spot rates to borrow to do so. Same, in my view, for a company. Cash/liquidity is king, and thereby that flexibility is king, in my view. There's no telling what tomorrow will bring. Too many macro things can happen to a company that are not indicative of the micro, company-specific stock, yet still move the stock (and almost all others) lower (or higher). What's the percentage of the S&P that move in tandem with the overall index? Whatever it is, it's high. Thing like, well, global thermonuclear war, subprime lending meltdowns, and 9/11. Company fundies don't matter much when we have a global panic. Same reason PM traded at 35 in 2009, a stock we both love. Since most stocks move with the general market, I'd rather a company have flexibility. Dare I borrow some sentiment from Bernanke or some lawmakers, but deficits don't necessarily matter that much (to me). Plus, if my house, or my stock, is viewed as the best house in a bad neighborhood due to my dividend yield, especially in a crisis, that dividend yield attracts more capital, I have thereby more flexibility, especially in times of trouble.

I jhink you might be taking a too micro, company-specific view of a stock or the fundies behind a stock. We both very well know stocks often move for no rhyme or reason sometimes virtually regardless of the company fundies. That's my only point, and I'd rather take money (dividends) along the way every single day of the week and twice on Sunday rather than rely on the macro sentiment of the market overall. I'm willing to bet there are a few others like me out there that feel the same way, and since the stock market is really nothing more than a market of stocks, that matters.

Great thread! 

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#10) On February 07, 2012 at 2:57 PM, TheDumbMoney (38.12) wrote:

I think it's a good set of questions.  You are very good at questioning conventional wisdom.

SkepticalOx's point is critical to the entire thesis for investing in dividends, though its impacts are very hard to quantify with regard to any particular company.

Second, I don't think we should view interest rates in isolation from inflation, and inflation expectations. Inflation erodes the cost of the (almost always fixed rate, and typically at least three years in duration) debt a company takes on, for one thing.  One can counter that inflation erodes value of the dollars returned as dividends, too, but that depends upon how investors use those dollars: they may invest them in another company that can grow faster than inflation, or in a well-timed real estate investment that will inflate in value. From the company's perspective, if its alternatives to dividends are: 1) sitting on the cash, which inflation will also erode the value of, or 2) reinvesting in its business if it is not sure it will be able to earn a profitable return on its reinvestments, or 3) paying down debt whose value will seriously erode in an inflationary environment, then paying dividends start to look like a fairly good idea. 

However, I too think that in certain scenarios it absolutely makes sense to pay down debt rather than pay dividends -- or at least pay additional dividends.  I also think there is a "hedging of bets" aspect to all of this, because of the inflation/deflation issues. But dividends of indebted companies are in some sense money gotten because of the credit-worthiness of the company, and transferred to the owners. 

Not coincidentally, a whole section of the private equtiy industry thrives on this very fact: 1) they buy an un- or under-levered company; 2) lever it up by taking on additional debt; 3) pay themselves and their investors a titanic "dividend" drawn from taking on the debt; 4) pay only 15% in taxes on their gains; 5) resell the company to the public; 6) rinse and repeat; 7) buy the same company again if after taking on all of that debt it goes bankrupt.  That, which does happen, is the clearest way to see how, by use of debt, dividends can essentially be a way to transfer the potential future gains of future shareholders, to current shareholders.

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#11) On February 07, 2012 at 4:42 PM, Valyooo (99.34) wrote:

mm5525,

I would normally agree with your point on flexibility > paying off debt.  However, there is no liquidity/flexibiltiy when you are paying a dividend.  Your case would be stronger if they were hoarding earnings, but if they pay out cash dividends they do not have that flexibility any longer.

 

dumberthanafool,

Glad to have you back.  I hope any beef between us is in the past. Yes, I am good at questioning covnential wisdom.  This usually does not work in my favor though because people either 1) think  I am being sarcastic 2) think  I am being an idiot 3) they dont understand what I am asking.  Oh well.

In regards to leveraged buy outs. What I never understood about them: If a company does that.  Lets say they pay $50 a share for ABC company.  They lever it up like crazy and pay themselves a $30 dividend.  When they resell it to the public, why would the public pay more than $20 for it?

 

 

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#12) On February 07, 2012 at 4:58 PM, TheDumbMoney (38.12) wrote:

"...why would the public pay more than $20 for it?"

Because of all of the new "efficiencies" the private equity people institute by firing people and changing who memos get sent to. I left that number out of the process. Also because IPOs are pretty and shiny and exciting.

I don't mean to sound entirely dismissive of this process. To the extent the private equity people are able to extract value, which they often are, it can only be because prior management failed to recognize the value in its own business, which is pretty sad.

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#13) On February 07, 2012 at 5:13 PM, mm5525 (< 20) wrote:

But if I pay off my mortgage, I still am admitting defeat, unless, of course, I have a vast amount of cash flow where it makes no difference to pay off the debt either way. If I have nothing better to do with my cash than pay off a debt, then I suppose it doesn't matter, but if I have a lot of cash, I ought to be able to refi higher-interest debt into much lower-interest debt, or sell bonds a little over spot Treasury yields with absolutely no problem whatsover, especially in this environment. However, even if you're right, and you are fundamentally, the market does not necessarily view things in a fundamental way. Case in point: AAPL has no debt and a ton of cash.... Market sell off? AAPL goes down... way down with the rest of the market. Perhaps back to the double digits where it was in 2009.  All riskier assets go down, and I'd argue particularly those equities that do not pay dividends, regardless of their balance sheet. At that point, it doesn't matter if you're fundamentally right, you're still losing more money than I am if I am invested in a safer haven, such as a PG with dividend protection, regardless of P&G's debt load compared to a non-dividend payer because I collected dividends all along the way and someone holding AAPL did not.

I also would disagree with you on the mere fact paying a dividend doesn't offer flexibility. Of course it does. Companies borrow to pay their dividends when it's prudent to do so, or if they have to. Most companies have debt, and just like if it's a retail investor and it is prudent to have debt for tax advantages or outperformance elsewhere, companies hold the same belief, at a larger scale. I think it's the same as buybacks. If it is prudent for a company to buy-back their own stock, even by borrowing the capital, it is still worth if as long as the shares are retired and the borrowing interest rate is less than the dividend. Still, I'd argue that a dividend paying stock will out-perform a non-dividend paying stock, even with a better balance sheet, most times.  

My view is it's essentially very difficult to argue against a shareholder getting returns along the way in the form of a qualified dividend versus someone relying on company fundamentals and sheer capital appreciation. I wholeheartedly maintain there are too many macro events that support me. Look at the global collapses we've had. The good go down with the bad. Dividend stocks provide better protection, even if were mere psychological, than a company that may have no debt, but also does not pay a dividend.

In the case of PM, if I am getting $6k along the way year after year in dividends, selling the stock even less than what I paid for it does not necessarily matter, because, in the end, I still am ahead due to those dividends, regardless of the company's debts. Macro, to me, is far more influential than a company-specific metric.

I also maintain it is very important to never get married to a stock. One must be liquid and nimble. If the world changes, you've got to be able to change too. These days, the fundamentals of the overall market can change in an instant in my view.  

In the end, I care about me. Not the company I invest in. Getting cash along the way regardless of market conditions is the way I choose to go, regardless of company balance sheet or fundamentals. Too many macro things will infuence the fundamentals. Just my $0.02 ;) Great discussion.

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#14) On February 07, 2012 at 5:54 PM, Valyooo (99.34) wrote:

Using the same logic that dividends help on the way down...what if we go into a recession and all of a sudden the companies start to lose money...which one is goign to go under, the one with no debt, or the one who isnt making enough to pay off their debt?  It is going to be the one with the debt who has a credit crunch.

I am a big believer in not getting overly concerned about the fundamentals, because at the end of the day the stocks that make you the most money are the ones people WANT to own.  Thats why costco trades at a high multiple, people like the way management treats employees.  nflx soared so high because amateurs loved it.  only people move the stock, not fundies. thats why BP traded at such a low multiple for a while.  But I am just talking theoretical here.

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