HomeBusiness DigestThe importance of dividends revisited

The importance of dividends revisited

THE just-ended reporting season on the stock market witnessed a diverse range of performances from companies; some recording unexpectedly good performances, a significant number coming in below market expectations, and others recording no

t-so-pleasing results.

Together with the earnings reports were the dividend announcements which were equally divergent, as some companies with phenomenal profits had little or no dividends, while others with small profits had relatively large dividends. The question then becomes: how important are dividends to the investor?

While investors in the global markets use several, often different factors in making their stock selections, the most popular tool in Zimbabwe is the price-earnings ratio.

Dividends have generally not played a significant role in the stock selection process, particularly in the last five years when inflation was rising, and investors were concerned more with capital appreciation rather than dividend income.

Companies made more by keeping money in working capital rather than in cash, and investors were generally assured that the value of their investment would grow, as long as the companies were not holding cash.

The price earnings ratio was therefore an appropriate tool for use in stock selection, as the earnings figure used in its determination captured the impact of changing prices through revaluations.

With the changes brought about by the fiscal and monetary policies introduced last year, however, comes a need to re-assess the validity and effectiveness of the price-earnings ratio as a stock selection tool.

The price-earnings ratio has come under criticism from many circles worldwide, mainly because of the earnings figure’s subjective nature. It is quite easily manipulated and the inclusion of items such as revaluation gains, depreciation, amortisation and foreign currency translation gains and losses in its computation also makes it somewhat meaningless when one compares this figure to actual cash-flows realised.

In a way, the same features that make earnings-based models attractive in a period of increasing inflation have become a drawback in this time of receding inflation figures.

A company can have a high earnings figure and still be on the verge of collapse because of liquidity and solvency problems. This has been illustrated very clearly from the events of 2004, particularly in the financial services sector.

While this does not necessarily mean that the earnings figure has become redundant in decision-making, it clearly shows the need for investors to consider factors other than the traditional price-earnings ratio.

Cash dividends on the other hand are non-debatable, not subject to manipulation and are understandable by everyone. They represent a real, tangible return to the investor on the capital they have deployed. Variations such as scrip dividends cloud the picture slightly, but again can be converted to cash values quite easily.

Dividends can be compared on a direct basis to returns on other markets such as interest from money market investments, or rentals from properties. They are thus important from a fundamental point of view; the whole point of investing is to realise returns — in cash — from one’s investments. For these factors, we believe dividends do present a viable alternative for the investor in making their investment decisions on the stock market.

Some analysts argue, however, that dividends are not important, as investors can realise cash by selling a part, or all of their holdings. They also argue that companies earn more value for investors by retaining profits and re-investing for even greater returns.

While the first argument is valid, the second one is not necessarily true as companies may continue to retain earnings well after their growth phase without expanding the business or generating greater levels of profitability.

Perennially failing to pay dividends or paying very low dividends compared to reported earnings also raises the question of whether reported earnings are there, or are merely a result of creative accounting.

While profitability and cash generation may not necessarily be directly related, and the timing of cash-flows may not coincide with the realisation of profits in the income statement, over a reasonable period of time cash must be realised and investors must know that this is happening — and dividends are an important way of conveying that message.

Conversely, questions arise when a company pays dividends inspite of apparent difficulties — is management trying to fool investors, or is the business really generating cash?

There is also the case of companies with declared dividend policies. When such a company deviates from its stated policy without giving convincing reasons for this (yet profit figures remain consistent) is there a cause for concern?

The question of dividends is therefore more complex than just investors wanting to be paid something. Globally it has been the subject of significant research interest. Dividends convey a message about the company’s health and future direction which investors should also pick, apart from the usual earnings per share figure.

Further information on this and other subjects is available on our website www.adway.co.zw.

Recent Posts

Stories you will enjoy

Recommended reading