Value Investing

Dividends and the Miscalculation of Total Returns

Most investors love dividends. They are tangible and a relatively secure form of returns by companies to their shareholders. A bird in hand is worth two in the bush right? That being the case, there are some, what I believe to be, misconceptions regarding the understanding of dividends in estimating total returns and the value of dividends under different investment styles.

Price returns versus total returns

A distinction has to be first made between price return and total return. Price return only takes into account the capital appreciation of a stock or a portfolio. Total return, on the other hand, factors in both capital appreciation and dividends received over a period of time.

Naturally, investors know that total return is the more comprehensive measure of rate of return. This is especially pertinent when evaluating stocks with high dividend yields. Take the example of a REIT whose price remains unchanged over a year, but has distributed about 7% of its share price as dividends. Clearly, the return to shareholders is not zero as it would be if measured on a price return basis. Total return is indeed the superior measure, but investors tend to get carried away in calculating the expected total returns of a stock.

Dividends and discounted cash flow

The issue usually arises when the popular discounted cash flow method is employed. Starhub had its 3Q results announcement earlier this week, and a research report from a certain bank contained the following:

DCF-based fair value: $3.91

Current price: $3.67

12m total return forecast: 12%

A simple punch of a calculator will tell you that the return based on current share price and the DCF-based fair value is only 6.5%. As per the definition of total return, the dividend yield was added to obtain the figure for total return.

But let’s take a step back here. From a fundamental approach, where do dividends come from? Are they ‘free’? Can companies pay out infinite dividends? The answer is obviously no. All companies are similar in the way cash is generated and expenses. Companies receive cash from the sales and profits of its core business. The cash is first spent on either maintaining fixed assets (which enable the business) or buying new fixed assets for expansion purposes. Whatever is remaining (called free cash flow) can then be used to pay debt and equity holders or kept in the company. The opportunity cost of any payment is that there is an outflow of cash (assets) and the value of the firm diminishes by a corresponding amount. It is for this reason that share prices usually fall by the amount of dividend per share when a stock goes ex-dividend.

Now, the discounted cash flow is essentially a present value figure of the amount of free cash flow entitled to the firm. As we have established earlier, dividends cannot materialise out of nowhere. Free cash flow is the source that sustains any future dividends. By adding dividend yield to a DCF-based fair value, the implicit – and erroneous – assumption is that the 2 forms of cash flow are mutually exclusive. In my view, it is a form of double-counting. But moving on, does it imply that dividends are of no value to shareholders?

The value of dividends

Given two companies with different dividend yields, but are similar in all other aspects; which presents a more appealing investment opportunity? Most would prefer the one with the higher dividend yield. I think it depends on the nature of the company. The key is that cash received as dividends can be reinvested a higher rate than if the cash was reinvested into the core operations of the company. This has direct implications on the value of dividends with regards to different investing styles.

In my eyes, dividends are a form of quasi-liquidation. For an investor who adopts a value-based approach, I would argue that dividends are preferred as value companies are often worth more dead than alive. Either that, or there is much pent-up value from its assets holdings and liquidation (in any extent) is the appropriate medicine for that malaise. On the contrary, Buffett-aspirants who seek companies which are able to self-compound over a long term will be wise to oppose any dividend payments. These companies usually have higher ROEs (>20%) and are able to earn much higher returns on any cash that is redeployed in the business than an investor can with it as dividends.

Final words

My sensing is that majority of investors prefer quality companies over value ones. Yet, there is also a majority of investors who view dividends as a positive signal. This, to me, seems like a mismatch. Many, too, double count the returns from free cash flow and the returns from dividends.

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