Dividends – Good or Bad?

Dividends decrease the total value of a company. Dividends are kind of like tearing off a small chunk of the firm and giving it to investors.

Let’s do an example – it’s a bit unrealistic, but stick with me. Suppose a company only holds $10 cash. The company sells all of its equity in the form of 10 shares. Theoretically, how much should these shares be worth? $1 each, for $10 total – the value of the company’s underlying assets.

Now suppose the company wants to pay a $0.10 dividend for each share. That means the company’s cash balance goes from $10 to $9. If the company only holds $9, how much should each share be worth? $0.90, for a total of $9. After the dividend, the shareholders hold $9 in stock and $1 in cash. The investors are no better off. If the company never issued the dividend, its total net worth would be the same at $10 in stock.

So, when are dividends a good thing? If a company has no profitable projects planned, then the money is better in the hands of investors. Let’s consider an example using a simplified McDonald’s. How many more profitable McDonald’s do you think your area could support? For my particular case, perhaps one or two. That means McDonald’s can spend money to help start two more franchises. If you’re a shareholder, that sounds great, right? Sure; but suppose McDonald’s has money left over to fund four or five more franchises. They’ve got the cash, but not enough viable projects.

This scenario is a problem for shareholders. Management will do one of three things with the leftover cash. It will either: give the money to shareholders as dividends or share repurchases; hoard the cash in short-term, low-interest-rate vehicles; or the company can engage in empire building. In the last option, the firm begins new projects even though the return doesn’t make sense. What’s a more impressive press release, opening 200 more McDonald’s or opening only 30 more this quarter? In a way, it’s a trick question – only if all the new stores are profitable ventures should the 200 openings sound impressive.

If the company has no projects with superior returns, the money is best put in the hands of stockholders. They can invest the dividends in other companies that may earn a higher return on the leftover funds. Or if the investors so desire, they can place those dividends into interest-earning accounts.

This logic behind dividends explains their presence in very large companies and the lack of them among growth companies and start-ups. Large, mature companies are often so big that they can’t always find new, likely profitable projects. After growing so much, the companies must search harder and harder to find new opportunities. That’s why many US companies from McDonald’s to Walmart are overseas. Nonetheless, large companies often end up with more cash than new ventures.

Growth companies are the complete opposite. They’re either creating new products or entering a new market. They should have investment plans for every cent and then some. If a company can earn 15% or 20% on its cash, it doesn’t make sense to give the money back to shareholders.

In general, here’s a good rule of thumb to keep in mind. Mature companies hoarding cash without a dividend is not a particularly good sign; and a growth company paying large dividends is definitely a bad sign in most cases.