The flipside of dividend distribution

Investors like dividends, more or less. The reward for investment, i.e. long-term ownership of businesses, are lavish dividends. If the company distributes a lot of dividends now, it often means that it could not find profitable investment targets. Investors prefer a growing dividend, which does not necessarily mean that the dividend rate needs to be high, but that the absolute dividend per share increases over time. For example, if the purchase price of shares purchased 10 years ago is compared to the current dividend, the dividend rate may be really flattering. Therefore, sustained ownership is particularly important for the long-term returns of the investor.

Receiving large dividends may initially sound good to the investor, but is it always a good thing in the long run? Let’s use an example to show how reinvesting retained earnings often generates a better outcome than paying dividends.

Which is more profitable in the long term, reinvesting of dividends by the investor or reinvesting the same capital in the business by the company itself?

The taxman takes his own

The taxman takes his share of the dividends even before they end up in the investor’s pocket. Depending on the investor‘s underlying factors, the tax rate may vary. For clarity, let’s use a private investor resident in Finland of who’s dividends paid by a listed company the taxman takes a capital income tax of 30% on 85% of the dividends. The remaining 15% is tax-free. This means that 25.5% of dividends are paid to the tax authority using these parameters. When the taxman takes his share of one dividend euro the investor is left with EUR 0.745 to be reinvested.

The investor then buys shares in company X with the dividends received. Let's assume that the company's P/B ratio is 3. Simplified, EUR 1 of company X’s equity costs EUR 3 on the market. For one reinvested euro, the investor owns EUR 0.33 (1/3) of company X's equity.

Let's combine the two previous transactions. For one dividend euro received, the investor receives EUR 0.745, for which when purchasing the same company the investor buys EUR 0.25 of the company’s equity (0.745/3) on the market.

By investing in business, the impact can be clearly positive

Instead, company X can keep the free cash flows generated by its business within the company and reinvest them in the business. In this case the produced euro will not be subject to a separate capital income tax as no dividends are paid, but the shareholder's share of this euro is 100%. When the free cash flow is reinvested in the business, the shareholder still owns 100% of the invested euro, whereas in the previous example, the investor held only 25%.

In addition, considering, as in the previous example, that the company is valued at a P/B ratio of 3, the market value of EUR 1 in profit is EUR 3. On the other hand, simply leaving the money in the company's account instead of the shareholder's account does not create value, better investment targets should be found for the money than what a shareholder could obtain from the market for this money.

Let’s assume that the company reinvests all the cash flows it generates from its business back into the business. If the company is able to allocate its free cash flow back to the business to create value (RONIC > WACC), i.e. at a return that exceeds the cost of the new invested capital and in this case an equivalent return on invested capital (assuming that the return on invested capital is 20%), the growth rate of the company's fair value is roughly 20%. Similarly, the outcome would probably be better, even if the company had investment opportunities to allocate at least half of the cash flow back to the business and half would be paid out as dividends to owners.

The fantastic compound interest effect

If the company can allocate the cash flow back to the business or new business for years, if not decades at a time, with similar return on capital (or simply return that exceeds the required capital return) the compound interest effect is fantastic in form of the ability to reallocate capital. In this case, it is inevitable that the outcome will be more economically sensible than paying dividends to owners simply for the joy of receiving dividends.

The situation is not always so rosy. It may be and often is the case that the company does not have projects/investment opportunities that exceed the required capital return, in which case distributing profit (free cash flow) to shareholders as dividends is at least desirable. In this case, owners can seek investment targets that meet or exceed the required return elsewhere.

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