The essence of capitalism is that the shareholders of a public company aren’t just “investors;” the shareholders legitimately own the business. It’s easy to forget, because you probably don’t play an active role in the companies that you’re a part owner of. Do you know how many companies you own a tiny sliver of via your 401(k)? Most investment strategies will include at least one index fund, most popularly an S&P500 fund, meaning you’ve got a piece of hundreds of different companies that you own. While many casual investors aren’t active in leveraging that ownership to make strategic decisions, they want the same thing as the people who are more involved: to make money on their investment in the company. You may not think of it that way often, but if you’re invested in a stock or mutual fund, you obviously want it to go up in value! If that weren’t your goal, you’d have that money in a bank account or a cash/stable value fund.
Different investors have different goals and values. Most are just people like you and me, investing money for retirement or major expenses like college for their kids or a house, hoping that our money is well-placed to grow and flourish in the market. Some are interested in controlling the company’s behaviors by electing members to the board of directors or even inciting proxy fights, where investors who are unsatisfied with one or more aspects of the company can gather up enough votes from other shareholders to elect new board members or convince existing board members to change their positions. Additionally, some investors are concerned with environmental or ethical issues, while others are simply there to maximize profits. Some investors are long-term driven, wanting to hang onto a company for a lifetime, while others want to capitalize on a market trend, boom, or fad, and harvest as much money as possible before dumping the shares. This isn’t an ethics discussion; it’s simply the nature of things that people have different wants, needs, and values that match their financial situations and personalities. Even among investors who are primarily focused on profit, there’s a major distinction between two types. These two types are both wanting the company to “return value to shareholders,” but have different preferences on how it should be done. Today’s discussion is on two major approaches to “returning value,” and the types of people who may prefer each.
Dividends
One way of increasing value to shareholders is to issue dividends. Dividends are cash payments that companies make to shareholders out of their profits. Coca-Cola (KO), a company famous for its long-term dividend policy, will pay investors $0.33 per share, per quarter in 2015.
Typically, dividends are issued by large companies who have limited growth potential. Coca-Cola has nearly worldwide market penetration. Try traveling somewhere where you can’t buy a Coke. As such, they don’t really need to reinvest a ton of their free cash flow. What would they invest it in? They’re a global, stable, cash-generating machine. In other words, they issue dividends because it’s the best way for their company to return value to their shareholders.
So what kind of investor prefers dividends? Conventional investing wisdom suggests that people approaching retirement should shift into more blue-chip companies — big guys like Coca-Cola that probably aren’t going anywhere anytime soon — to protect their invested assets and to replace their incomes with dividends upon retirement. Many retirees look to annuities, where they turn their lump sum investments into regular, steady cash flow to live off of after they stop drawing a paycheck. A dividend-heavy portfolio accomplishes something similar, with greater risk because the stock can decline, but also greater potential since the company can still appreciate in value or increase their dividend payout.
As an example, if someone wanted to make $100,000 annually in retirement, they could do a calculation to see how much Coca-Cola stock they needed to own to produce that. At $0.33 a quarter, each share of Coke makes $1.32/yr. You would need 75,758 shares to make $100,000 in 2015. At the time of this writing, Coke’s share price is $41.08, so to generate a $100k annual income, you’d need around $3.1M in Coke stock. That’s a lot of money, but you can see how dividends could play an integral part in someone seeking to get cash back out of their investments while preserving their value (and even continuing to grow it).
Share Repurchases
An alternative way for companies to increase shareholder value is to purchase their own shares off the market. There are a couple different ways to do this, and some other reasons besides shareholder wealth that companies may buy back shares, but generally, the results are the same: the company’s value stays the same, but since there are fewer shares, the value of each share increases. This directly puts more money in the investors’ wallets.
Here’s an example. Let’s say a company has 50,000,000 (50M) shares on the market at a price of $100 each. The company’s market cap (total value) is 50M shares times $100/share, so $5B. If the company purchased $100M of their shares back, they would remove 1M shares from the market. There are now 49M shares outstanding. The company is still worth $5B total though, so the share price will adjust accordingly — $5B divided out over now 49M shares instead of 50M equals $102.04 per share. The share repurchase gave an immediate 2.04% return on every outstanding share. Not bad for a day’s work! There used to be another reason shareholders preferred repurchases over dividends. It used to be that dividend income was taxed at normal income tax rates, while share appreciation was subject to the lower long-term capital gains tax rate. That changed in 2003 so dividends are now taxed at the capital gains rate.
You might have already guessed what kind of investor or company prefers increasing share value over cash payouts. Not surprisingly, it’s the opposite of the dividend-preferring crowd. Younger, more aggressive investors want share values to increase. They’re still working and investing for the distant future. They want their investments to compound, and they don’t care about cash, since they’re not planning to use it for decades! Also, while large companies with high levels of market penetration are more likely to generate dividends, since they don’t have a lot of growth potential even with massive reinvestment, smaller companies benefit tremendously from reinvesting in the value of the company and its future growth.
The Bottom Line
At the end of the day, when a company exercises either of these options, it’s usually a signal of strong earnings and solid financial standing. Different companies, different boards of directors, and different people will want different things out of their investments. But if your company is putting a high priority on “increasing shareholder value,” it generally means that things are pretty stable on the homefront.
As you listen to your earnings in the future, listen for investors to start calling for these options, directly or indirectly. As I always emphasize, it’s the intangibles that make earnings calls interesting. If your analysts are concerned about the future of the company, it signals one thing. If they’re seeing dollar signs, they’ll start to ask for a piece. See if you can catch it next time you listen in!
For more information on share repurchasing, see: http://www.investopedia.com/articles/02/041702.asp