Should we choose to buy companies that pay lots of dividends or companies that pay very little dividends but create a lot of shareholder value?
Berkshire Hathaway, Warren Buffett’s company has not paid a single cent in dividend so far. All the profits accrued are all pumped back into the company to make the company grow. That’s the reason why it’s now the world’s most expensive stock at $115,815/share now. Warren Buffett says that every dollar of retained wealth by the company should create a dollar of market value. If the company cannot do so, it should return the money to shareholders via dividends so that the investors can invest the money elsewhere. Since shareholders want the value of the business to increase, Warren Buffett ploughs the company profits back into his business as he believes he can create the value.
Personally, I prefer the company to retain its profits and invest into its own company to create more value. If it cannot do so, the profits should be returned to the shareholders, just like what Buffett believes. If the dividends paid yearly increases with increasing share price, then it’s a great buy. However, before looking at the dividends, it should be analyzed if the company can create profits year-on-year and thus increase its yearly dividend payout. It should also fulfil all the other value investment criteria like low debt, high ROE, high free cashflow, etc.
To see if the company can pay out dividends consistently and with increments, I look at whether the free cashflow generated yearly increases. I also look at historical dividend payouts and if they were increasing year-on-year. I prefer to invest in companies with dividend yield of more than 4-5%. However, if the dividend yield is low but the company has been growing astoundingly with high ROE, I might still invest in this company as the profits are ploughed back into the company to generate more profits.
Let’s see what yearly increments of dividends can do to the dividend yield. Let’s say you bought a company, Dividends So Shiok Pte Ltd (DSS for short). The price you bought at was $5. The total dividends paid for the first year was $0.30. This gives a dividend yield of 6%. 10 years later and you are still holding on to the stock. The dividend growth rate and share price growth rate is 6%. At the end of 10 years, the stock price will be $8.95 and the dividends for the year will be $0.54. The dividend yield now becomes 10.8% on your original $5 investment. This is the power of compounding.
Lastly, always remember not to use your dividends to splurge on stuff. Use the dividends to buy more stocks to compound your growth.