Should you chase dividends?

Dividends can be a great way to give your income a boost, but you should avoid choosing investments based on dividend payouts.

Companies that produce high returns on equity, have manageable debt levels, and the potential to advance their businesses and value through growth opportunities will ultimately serve you better in the long run by reinvesting earnings back into those businesses.

But what if you rely on investments for that extra income? When a business is properly reinvesting its earnings, you can still create your own dividend-type capital by selling a portion of your rising shares.

Here’s an example inspired by Warren Buffett’s annual letter to shareholders.

First, let’s make the following assumptions:

• You are the sole owner of a company that has a net business worth of $1 million;
• The business earns 12% annually on its total net worth, and you can earn the same rate of return on reinvested earnings;
• The business can be sold to an outsider at 125% of net worth at any time;
• To satisfy your current investment income needs, one-third of annual earnings will be paid out as a dividend, and the remainder will be reinvested in the business.

Scenario 1: pay yourself a dividend

Your $1 million business generates a $120,000 return in your first year of ownership. As a result, you pay yourself a dividend of $40,000 (one-third of earnings) and reinvest the remaining $80,000 into the business.

This reinvestment will ultimately grow at 8% (equivalent to the 12% the business earns, minus the 4% that’s paid out as a dividend).

After ten years, the business has a total net worth of about $2.16 million, which can be sold for roughly $2.7 million (125% of net business value), and the dividend in the upcoming year will have reached $86,357.

This is a great investment proposition that will produce lucrative returns.

However, there is an alternative approach that’s even better.

SCENARIO 2: Reinvest all earnings in the business

To create income from your investment, you will need to sell a portion of your shares every year to raise cash. Let’s call this the synthetic approach to creating a dividend.

To generate the same $40,000 dividend received during the first year in the prior scenario, sell the equivalent of 3.2% of your outstanding shares (at 125% of net worth).

After 10 years, the total net worth of the business grows to just over $3.1 million.

However, because you’ve been selling 3.2% of your shares each year to simulate a dividend, your ownership of the company decreased from 100% to 72.2%. This portion is worth about $2.24 million, and can be sold to another investor for just over $2.8 million.

Despite the reduced stake in the business, your remaining ownership is worth more than 100% ownership in the previous dividend-paying scenario. And you’ve generated a great deal more income, with the sell-off dividend reaching over $124,000 in the 11th year of ownership.

Allowing the company to reinvest all its earnings and create its own dividends leaves investors with more cash in their pockets and greater net worth.

Reality check

The average profit margin for companies that make up the S&P 500 in 2012 was 13.4%, about the same as the 7-year average. And although we said shares could be sold for 125% of net worth, the 500 companies that make up the index actually sold at an average price of 230% of book value over from 2006 to 2013.

Dividends paid out by a company impose a specific cash-out policy on all shareholders, but each shareholder has differing needs for income.

A company can try to keep shareholders happy, but it can’t satisfy everyone.

Meanwhile, the synthetic dividend approach allows you to make your own decisions when it comes to receiving or building up capital.

And while dividends are taxed in the year received, the sell-off approach gives you the added control of deferring taxes to the new year, if you sell shares in January 2014, as opposed to December 2013, for instance.

Also, all cash received in the form of a dividend is taxed, while the synthetic approach is only taxed on one half of the capital gains portion of the cash raised.

Many income seeking investors shy away from companies that do not pay dividends, but, in the long-run, by focusing on strong businesses, your portfolio can outperform dividend paying investments and still boost your income along the way.

Susy Abbondi is a portfolio manager at Duncan Ross Associates.