Friday, February 3, 2012

How Companies Pay Back Shareholders.

Some companies pay dividends, some do not.
Are there ways to pay shareholders other than through dividends?

Presuming a company is really profitable - and that is a big presumption these days - there are a number of ways a company can "pay back" its shareholders, and not all of them involve dividends.

Why do companies pay shareholders in different ways?  Well, as we will see, for tax reasons, growth reasons, and other reasons.

1. Dividends, are the most traditional way of paying shareholders - and yet probably less than half the companies out there pay them.  Why is this?

Well, for starters, from a tax perspective, the dividend is the worst way to pay a shareholder.  Suppose XYZ company makes $100,000 a year in profit.  It pays a corporate tax (presuming they don't have some way of legitimately avoiding this - and there are many) of 35% or $35,000.  So that leave $65,000 in after-tax profits.

Let's assume there are 100,000 shares of stock outstanding.  That means each shareholder earns 65 cents a share.  The Board of directors decides to pay this out as a dividend of 65 cents a share, either annually, or by dividing it by four and paying in quarterly installments.

Each shareholder now has to pay ordinary income taxes on this money.  And how much they pay, depends on what tax bracket they are in.  For very wealthy people, this could mean another 35% - reducing their profit to a mere 30 cents a share.

As you can see, this technique does two things:   First, it creates a taxable event for shareholders by declaring a dividend.  Second, it forces the double-taxation of profits, which can be as high as 70%, which is a staggering amount of money.

This is one reason I don't lose any sleep over Corporations "not paying any taxes" - the double-taxation system we are under is onerous, and even if GE avoids paying taxes on its profits, I, as a shareholder (and bondholder) most certainly do pay taxes on my share of it.

So, from a tax perspective, paying dividends is a lousy way to pay your shareholders.  But there are other downsides as well.

If your company needs money to expand, paying out all the profits may leave the company broke, which means the company will have to borrow to expand, increasing its operating expenses.  In addition, it is nice to have a reserve of cash-on-hand, and if you pay out all your profits as dividends, well, you can't go back to shareholders and say, "Gee, we need that money back."

And of course, the whole idea of "what is profit?" is a problem.  A company can show a profit on paper, pay out a dividend, and end up eating its own tail - slowly consuming itself for short-term profit (and payout to shareholders) when in fact it is running in the red.  Accounting techniques are always suspect, which is why I say it appears Facebook is making money, but then again, so was Enron - according to their accounting procedures.

What are the pros of paying dividends?  Well, it drives up the stock price.  Nothing says "we're profitable" like paying out dividends.  And for many "old line" companies, where profits are predictable, this is the way to go.

Paying out dividends also means the company doesn't have a lot of cash lying around, which as we shall see, can help prevent it from being a takeover target.

2.  Buying Back Stock is another way to pay your investors.  If you take the surplus cash on hand and buy back company stock, it increases the price of the remaining stock (or it should) as each share is, in theory, worth a larger slice of the company.

So, for example, our XYZ company has $100,000 in profits.  It decides to buy back its stock instead of paying a dividend.  Now, it still has to pay corporate income tax (because their accountants are not too clever, it seems) and this leaves $65,000 leftover to buy stock with.  Again, we have 100,000 shares outstanding, and let's say the stock is trading at $10 a share.   They buy 6500 shares on the open market for $10 a share with this money.

Now there are only 93,500 shares outstanding, and theoretically, each share is now worth about 6.5% more than it was before.  At $10 a share, this means each share of stock is worth 65 cents more than it was - or about the same as the dividend scenario above.

The nice thing is, this does not create a taxable event for the shareholder, until they decide to sell their stock.  Until they sell the stock, no realization event has occurred.  So, while the company may have had to pay corporate income tax (ha-ha, not likely) the shareholder pays no tax - until they decide to sell.

When they do sell, what tax do they pay?  Well, regardless of tax bracket, they pay the 15% Capital Gains tax (the "Mitt Romney" tax bracket) which is lower than all but two of our ordinary income brackets.  Yea, Mitt pays the same rate as as chumps making $63,000 a year combined (married) income.  But of course, he pays no Social Security tax on Capital Gains, so in effect, he pays even less.  Oh, yea, it is a sweet tax system, if you are making a lot of dough.

Can't say I never took advantage of it, myself.  Now that I am in the 15% (income) bracket, the incentive is a lot less, though.

So this technique defers taxes and even when they are paid, it is at a far lower rate than income taxes.  Pretty sweet deal!

Downsides?  You can buy back shares and the share price may not go up by the amount you buy back.  The market is imprecise, to say the least, in evaluating share value.  So a company might buy back 10% of its stock, and the price of the stock remains flat.  Ford did this in the 2000's - buying back stock - but the share price didn't go up much, if at all.

And again, it leaves the corporate coffers empty, so you don't have cash-on-hand to pay bills or to expand - although you can always sell more shares if you need that money, I suppose.

3.  Retained Earnings is yet another way to pay back shareholders, but like buying back stock, only indirectly.

Again, using our example of XYZ company, we take this $100,000 profit and just keep it in the company bank account - or perhaps invest it in stocks or bonds.  Again, we pay corporate income tax (need to fire that accountant) so that leaves $65,000 to invest.

The net effect is that XYZ company is worth more as it has more cash on hand.  If you had to liquidate the company and hand out that money, well the shareholders would get more.

In our example, the stock was trading at $10 a share and there were a 100,000 shares, or a market capitalization of $1,000,000 (one million dollars) even.  We add this $65,000 to the bank account of the company and the company is worth that much more.   Arguably, 65 cents a share more, although again, the market never evaluates share prices that precisely.

Again, since an increase in share price is not taxable until you sell, retaining earnings is not a taxable even to shareholders, and when the shareholder sells, he pays only the Mitt Romney tax, not the ordinary income tax (15-35%) we working chumps pay.

And this approach leaves the company with money to expand, fall back on, operate with, etc., which leaves management with more flexibility.

And if invested properly, this cash could earn more cash - and make more money for the shareholders.

Downsides?  Well, if they invested the excess cash in stocks, and it went down, then the company loses that money and the value of the company decreases.  Also, there is the temptation for management to spend or squander the money - by making poor choices to expand (or acquire companies) or by not being as efficient as a cash-strapped company might be.

And many companies fall into this trap - feeling they "have to spend" that money, so they buy a lot of start-ups and other companies, that are not really worth what they paid for them.  Having a lot of money in your wallet is a temptation to spend - whether you are an individual or a corporation (which the Supreme court says is the same thing).

But one big problem with having a lot of cash floating around is that it makes your company an attractive take-over target.

Say XYZ company has $65,000 in cash on hand and invested securities.  The stock price remains flat at $10 a share (remember, the market does not always accurately reflect actual values!).  Maybe after a few years of this, they end up with more money on hand - hundreds of thousands, in fact.  Say, after three years of this, they now have close to $200,000 in the bank.

A smart young Venture Capitalist, who, in this example is NOT Mitt Romney and Bain Capital (they would never, ever do things like this!) Decide to offer to buy XYZ corp from the shareholders for $11 a share.  Since the company is trading at $10 a share, this seems like a good deal to the shareholders (a 10% gain) and moreover, a sweet deal for the Officers of the company, who are paid mostly in stock options and at a $10 option price, aren't making bubkis.

So the deal goes down and the VC's take over the company.  They take the various divisions of XYZ company and spin them off, perhaps spiffing them up for resale - cutting payroll and de-contenting products.  So they get a million bucks for the company, maybe a little more.

But that leaves all that sweet cash in the bank account, which the VC's pocket as pure profit, once they have sold off the company.  Not a bad rate of return, particularly when you consider that they probably used someone else's money to leverage the deal.

Now take those numbers and multiply them by a factor of a 1,000 or 100,000 or more, and you get an idea how this takeover and spin-off game can be played, and is played, on a national scale.  You can make a lot of money buying up a company, chopping it up, and then spitting it out, while keeping all the cash-on-hand for yourself.

So having a lot of cash lying around - like Apple does - can be a bad thing, if your company is undervalued (which Apple is not).  And of course there are ways to avoid these take-overs, using so-called poison pills (which buyback stock,  acquire divisions, take on debt, pay out dividends) to make the company less attractive to predators.  Like the poison-dart frog, the predator bird will spit it out, once it gets the bad taste in its mouth.

* * * 

Now the chart at the top of the page shows that dividend paying stocks tend to do better than non-dividend paying stocks.  Why is this?  Well, not all non-dividend paying stocks are paying the shareholders through alternate means.

Some are losing money - and continue to lose money.  These companies cannot pay a dividend if they wanted to.  And they are counted among the "non-dividend paying stocks" in the chart above, which brings down the average.

Tech stocks often don't pay dividends because they need the money to invest in expansion.  They need to keep coming up with the "next big thing" to keep competitive and make money.  Apple is in this trap.  Flying high today, but what about tomorrow?

Now, if you are a very simple thinker, like myself, you may ask yourself, "Well, that makes sense, but when do the shareholders cash in?"  And the answer is, well, you have to hope that some other fool will pay you more for the stock than you paid for it.

For example, going back to XYZ company, let's assume XYZ is a "dot com" company.  They have a lease on some office space in Silicon Valley.  This is not an asset, but a liability.  They own some servers and desktop workstations, a lot of cubicles and office furniture, some photocopying machines, and that's about it.  The liquidation value is maybe $100,000 at auction - about 1/10th its vaunted "market capitalization" of one-million dollars (the number of outstanding shares times the share price).

You might very well ask, "well, why is this company worth $10 a share, when its liquidation value is only $1 a share?"

Good question.  And the answer in part is that it is bringing in $100,000 a year in pre-tax profits, a profit margin of 10% of its market cap, which is a pretty good rate of return (a P/E ration of 10).  So while it may not be worth much in liquidation value, the company is a money-making machine.

But, you say, you never see that money, really.  The company, like most tech companies and start-ups, retains those earnings to invest in new technologies or perhaps buying smaller, related companies.  The liquidation value does not increase by very much.  How am I, as a shareholder of XYZ making any money?

I mean, somewhere along the line, something tangible other than the market-determined share price has to come out of this, right?

And I agree with you, and this is where stock prices get a little Hoo-Doo on us.  People value stocks based on P/E ratios, even if that "E" - the earnings is never paid out to shareholders, but rather is retained earnings.

And the problem, for tech companies, is that while this game can go on for years and years - using earnings to buy out competitors and startups, expanding the business, investing in more technology - eventually the company hits a brick wall.   Technology changes.  Management bets on the wrong technology, or is utterly inept.  Or someone starts robbing the place from within.  And while the company made "profits" all those years, none of the shareholders ever saw any of them.  So the company goes belly-up and liquidates, and the shareholders get pennies on the dollar - if that.

It is, to some extent, a game of smoke-and-mirrors.  Which is why investing in tech stocks is so risky and why something like the Facebook IPO, even if properly priced (at about 3-5 times LESS than its current market valuations) is still a hugely risky business.

You have to hope, as a shareholder, that the price of the stock keeps going up - that the supply of chumps who really don't understand the valuation of the company keeps increasing.   And in a good market, the chump supply does seem endless.

The problem, for the small investor, is that we are usually the last ones in - the chumps who pay the retail price for a stock, that jacks up its "market cap" into the stratosphere.  Joe Retail Consumer is the guy who will pay $50 a share for Facebook, not realizing that 95% of the outstanding shares were awarded to people in lieu of pay, or sold to early investors for far less than you paid.

Non-dividend paying stocks are, to some extent, a pig-in-a-poke, even if you can make money on them, at times.  Dividend paying stocks are no panacea, either, of course - you can lose your shirt on those as well.

So what's the answer?  Well at the risk of sounding like a broken record - diversify.  Put some in dividend-paying stocks, some in non-dividend paying stocks.  You might even risk a small portion of your portfolio on tech stocks - and hope to hit it big.  But also buy bonds - government or otherwise.  Life Insurance.  CDs.  Savings Accounts.  Real Estate.  And of course, paying down debt is a 100% safe investment for the small investor.  Have a plan to get out of debt and stay out of debt, by the time you retire.

If you "invest" in a number of different things, you can't get burned completely when one of them goes bad.