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'Looking' beyond dividends... - Views on News from Equitymaster
 
 
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  • Jul 13, 2007

    'Looking' beyond dividends...

    During the first half of the twentieth century, investors believed that companies rewarded shareholders primarily by paying dividends. The past fifty years, however, have witnessed the acceptance of the notion that the profits not paid out as dividends - that are reinvested in the business, also increase shareholder wealth by expanding the company's operations through organic and inorganic route or by strengthening the shareholder's position through debt reduction or share repurchase programs.

    Berkshire Hathaway Chairman and CEO, Warren Buffett, created a metric for the average investor known as 'look-through earnings' to account for both the money paid out to investors and the money retained by the business. The theory behind his look-through earnings concept is that all corporate profits benefit shareholders whether they are paid out as cash dividends or ploughed back into the company. Successful investing, according to Mr. Buffett, is purchasing the most look-through earnings at the lowest cost and allowing the portfolio to appreciate over time.

    The legendry investor in one of his letters to the shareholders of Berkshire Hathaway insisted that investors must benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a company) that will deliver him or her the highest possible look-through earnings in a decade or so.

    An approach of this kind tends to force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It is true, that, in the long run, the scoreboard for investment decisions is the market price. But prices will be determined by the future earnings. Quoting Buffet, "In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard".

    Correspondingly, dividend payout and dividend yield are not yardsticks to be done away with, albeit judgmentally. High dividend payouts are usually associated with the completion of long tenures of operation or exceptional profits. However, a business earns exceptional profits only if it is the lowest cost operator or if the supply of its products or services is limited. The limited supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then it unceasingly faces the possibility of competitive pressures.

    High dividend yielding stocks are generally those where growth prospects are very slow and companies distribute a larger share of the profits, as they find no opportunity to invest excess cash. Secondly, if the dividend yield is low, then the stock is not an attractive investment opportunity in most cases as the price may have run up very sharply.

    Thus, without considering the company's willingness to part with cash dividends or its reluctance to do so, in isolation, investors must evaluate the operational and competitive standing of the company with relevance to the same.

     

     

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