After observing companies for a decade now, I have come to the conclusion that dividends unlock value for shareholders. Let me start off with an actual example.
A few months ago, Costco (COST) announced that it would be paying a special dividend to shareholders.This event alone unlocked hidden value for shareholders.
On April 26, 2017 Costco announced special dividend of $7/share to shareholders on record from May 10, payable on May 26, 2017. The stock price rallied to 178.05/share at the opening and closed at $176.80/share on April 26, which was up from the close of $172.68/share on April 25. The stock closed at $172.64 on the ex-dividend date of May 8, and it had closed at 180.20 on May 5. In this case, the special dividend unlocked hidden value in the enterprise for shareholders.
That amount of money was locked in the business, and was not put to productive use for shareholders. This is why the company’s rational management decided to distribute the money to shareholders. This is the rational thing to do, when you are showered with cash, and you do not have a lot of high ROI projects to invest into. That $7/share were sitting in cash, but were not fully baked in the stock price, until the announcement unlocked this hidden value for shareholders.
I went back to look at the history of prior special dividends for Costco. I was stunned that every single special dividend ended up unlocking value for the shareholders. What I mean by “unlocking value” is the fact that the share price increased as a result of the special dividend announcement. So shareholders were better off as a result of the special dividend in every single case.
Those examples were discussed in a previous article, where I argued that paying a dividend does not reduce a company’s value. Here are the two examples:
On November 28, 2012 Costco announced special dividend of $7/share to shareholders on record from December 10, payable on December 18, 2012. The stock price rallied to close at $102.58/share on November 28, which was up from the close of $96.51/share on November 27. The stock closed at $98.47 on the ex-dividend date of December 6, and it had closed at 105.95 on December 5. In this case, the special dividend unlocked hidden value in the enterprise for shareholders.
On January 30, 2015 Costco announced a special dividend of $5/share to shareholders on record from February 9, payable on February 27, 2015. The stock price rallied to close at $142.99/share on January 30, which was up from the close of $140.64/share on January 29. The stock closed at $149.09 on the ex-dividend date of February 5, and it had closed at 155.92 on February 4. In this case, again the special dividend unlocked hidden value in the enterprise for shareholders.
Yes, a little before the dividend is paid, the stock will go down on the ex-dividend date. But, do not forget, the stock went up when the special dividend is announced out of the blue.
A lot of people look at the drop at the ex-dividend date, and reach out all types of crazy conclusions that dividends do not matter, or that a share buyback is the same as receiving a dividend, or that selling stock is the same as receiving a dividend.
They are wrong.
They forget to see that the stock price in between ex-dividend dates also slowly accrues the dividend payment to the shareholder. In other words, a quarterly payment of 90 cents/share would slowly accrue at a daily rate of 1 cent/share, which is obfuscated in the daily mess of stock fluctuations. When a company has a firm dividend schedule on hand, investors expect it to be paying that dividend amount (hence the regular dividend expectation is baked into the price).
A company that pays a dividend routinely unlocks value for its shareholders, by distributing excess cashflow to the rightful owners. This is money that is not needed in the business, that would have otherwise gathered dust on the balance sheet. When you have too much idle cash sitting around, the odds of it being squandered away greatly increases. Dividends on the other hand impose discipline on management, that forces them to invest in worthwhile projects that have a high chance of delivering ROI above a certain threshold. Since paying a dividend is a routine event that happens every quarter, the accretion of value is not easily noticeable for the untrained eye. A special dividend announcement is highly visible on the other hand.
In the case of Costco, this special dividend has unlocked value for shareholders. It is obvious that they are better off with the dividend, rather than without it. Paying a special dividend is superior to share buybacks, because it provides options for shareholders to allocate the money as they choose. The special dividend is also superior to share buybacks, because every shareholder receives the same amount of value per share at the same time. A share buyback on the other hand takes time to complete, management may not follow through with it all the way to completion. In addition, in the case of Costco, it would have been dumb to repurchase shares at over 30 times earnings.
A company like Costco could have bought back shares regardless of the fact that it was selling for over 30 times forward earnings, and the slowing growth in earnings per share. The problem with the share buyback is that the stock price is overvalued today.
A company that repurchases shares without looking at the intrinsic value they are receiving, for the amount of money they are giving up, could be wasting your shareholder dollars. That doesn’t mean stock prices can’t get more overvalued however. Costco could have repurchased shares when the stock was selling at over 20 times earnings in 2012, and it would have been a great decision in retrospect. The company grew net income from $1.7 billion in 2012 to $2.35 billion by 2016. Investors also assigned an earnings multiple of 33, up from roughly 24 - 25 at the end of 2012. Of course, if the valuation multiple were to shrink to 15, repurchasing shares would have seemed like a not so good idea. If retire half of shares outstanding when your stock sells at 30 times earnings, but the PE compresses to 15, you would have done nothing to add value to investors.
With the benefit of hindsight,