Dividends Unlock Value

Cash sitting on company balance sheet that's not utilized earns no/small return. There's a risk it would be pissed away/wasted on low roi m&a, corp jets, exec comp. 

1. Sending that cash to shareholders, who can deploy at 10%/year (historical annuialized return on US Stocks) is better than having that money rot away at much lower, if any returns.

2. Unused cash on balance sheet is valued at a discount by marketplace, due to lack of visibility as to what would happen to it. Would it be pissed away on corp jets/pet projects or just invested without any thought of profitability?

Cash on the balance sheet is not always going to be valued at 100% by the market.

It’s very likely that this cash on the balance sheet is valued at a discount. 

That’s because there is an opportunity cost to that cash. There is also the possibility that this cash is wasted on bad acquisitions, purchases, corporate jets, management perks. If you have too much cash on hand, the possibility to piss it all away in a heartbeat increases exponentially. Plus, there is a time value of money cost, where the present value of a future outlay is lower and lower the longer you have to wait.

For example, if I receive $100 today in my bank account, I will have $105 in 1 year at a 5% interest rate.

But, if I have to wait to receive that $100 in one year, I am now $5 poorer. (because I miss out on generating a return on that money for a whole year)

Hence, by paying a dividend, the company actually unlocks hidden value that’s stuck on the balance sheet.

There's some research out there that shows that  governance has a substantial impact on value through its impact on cash: $1.00 of cash in a poorly governed firm is valued at only $0.42 to $0.88. Good governance approximately doubles this value. Link: Corporate governance and the value of cash holdings

If a company does not have uses for cash, it’s going to sit unused on the balance sheet.

As I mentioned above, there is an opportunity cost attached to unused cash on the balance sheet. It gathers the dust of opportunity cost.

For example, if that cash sits on the Balance Sheet earning a minimal return of say 4%, it’s not going to amount to much. It’ll possibly fail to keep up with inflation over time by much.

However, if that cash is distributed to shareholders, they can put it to good use. Long-term returns in the US  Stock Marekt are at 10%/year. 

Hence, investing that money as a shareholder at 10%/year sure beats having that cash gather dust on the balance sheet and make only 4%/year.

Sending this excess cashflow out to shareholders is helpful, because they can reinvest it at a high ROI elsewhere. If they reinvest it into a portfolio of other investments, these shareholders are further diversifying their investments. After all, many companies end up failing. Hence, the prudent thing to do would be to wring out any excess cashflows from them while they are still operating as a going concern, instead of it being pissed away on M&A or executive perks or low ROI projects, and invest it prudently into a diversified portfolio of American Businesses. 

In general, I am a proponent of the idea where businesses reinvest only the cashflows that can be invested at a high hurdle ROI rate. Anything that cannot be deployed intelligently at such a rate, should be sent out to shareholders. 

This is the framework that no other, but Warren Buffett effectively uses at Berkshire Hathaway. He lets managers manage businesses at they see fit. However, when it comes to capital allocation, he asks that they only reinvest capital back into their business, provided they earn a minimum rate of return on these projects (e.g. 15%). If they cannot deploy capital at this hurdle rate, he asks that they send this excess cashflow to him, so that he can deploy it intelligently elsewhere.

These are just a few high level thoughts I have on the topic. I can expand further in future posts.