This video post asks business owners and advisers two questions: 1) Is your company’s (or your clients’ companies for advisers) dividend policy a good one that is meeting the needs of its owners for current income versus capital appreciation? And 2) If not, do you need to be working on your dividend policy to improve its effectiveness?
Your company or your client’s company has a dividend policy.
I’ll begin this Valuation Video from beautiful Port Orange, Florida and my makeshift board with two questions: One, is it a good dividend policy? In other words, is it meeting the needs of your shareholders for income and capital appreciation? Or, two, do you need to be working on your dividend policy?
In the last written post, I talked about dividend policy. I’ll continue in this video post.
Every company has net operating income after taxes, and there are five things that you can do with it. Number one, you can repay debt, the principal on the debt, and that’s a good thing because lenders like to be repaid. Two, you can invest in working capital, because growing companies need working capital to finance inventories and accounts receivables and current operations. Three, you can replace your existing capital stock when it depreciates. Four, you can invest in growth capital expenditures. And, if there’s anything left, number five, you can distribute to owners. These five things are the five things that you can do with that operating income. The first four yield the appreciation of the business, and the capital appreciation of the business is a component of the total return to shareholders. The fifth, the dividends are economic distributions, or distributions after taxes, that provide current returns to shareholders, or the dividend yield. And the total return is equal to capital appreciation plus the dividend yield.
There are a variety of kinds of companies, of course, and companies have different life cycles. Let’s consider a company that is mature. There are very little required expenditures needed to repay debt, or to invest in working capital, or to invest in capital expenditures for growth. And, consequently, this company may provide heavy distributions, or, number five. Now consider a company in the growth phase, all of its net operating cash flow, net operating income, might be consumed with repayment of debt, working capital replacement, capital expenditures, and growth capital expenditures. And so there might be no dividend. In the mature company, the total return would be low in terms of capital appreciation and high in terms of dividend yield. With the growth company, the total return should be high in terms of capital appreciation and low or none in terms of the dividend. So companies can have a variety of dividend policies.
Let’s just look at a couple of them and mention them. Number one, a constant dollar policy. Your company may be paying a hundred thousand or a million or three million dollars a year, and you’ve been paying that for a long time, and you plan to continue to do that. Next, a percentage of income. Some companies pay out about 40% of net income, 20% of net income, something like that, so a percentage of that income. Next, a constant yield some companies have valuations every year, and that’s a good thing, and then, they pay their dividend based upon a set percentage of value. Perhaps, one percent or three percent of the current valuation. Some companies occasionally make a special dividend. Some companies have an occasional, or sporadic, dividend, and some companies never pay dividends. Still, other companies don’t pay dividends but accumulate cash, and that diminishes the total return for all the shareholders, which is not a good thing.
So now we have two questions: 1) Is your company’s dividend policy a good one? Is it meeting the needs of the shareholders, their desires for current income versus capital appreciation? Is it? Well, if it’s not, 2) Do you need to work on it to improve your dividend policy?
If you need to work on your dividend policy, feel free to call me or feel free to call any of our professionals in our Family Business Services Group at Mercer Capital. We will work with you to develop a better dividend policy for your company.
Until the next Valuation Video, this is Chris Mercer. Good day.