Thursday, October 06, 2005

Is a bird in the hand worth two in the bush?

Yield plays have been an investment theme for several months. In particular, hot money have chased up the price of high yielding counters like M1, Yellow Pages as investors focus on the importance of income. Some initial public offerings such as Courage Marine have also outlined a clear dividend payout policy in hope of enticing demand. In a market with no clear direction, the appeal of dividends lies in the reasonable certainty of an income stream over capital appreciation. Indeed, the proverbial bird in the hand appears to be worth more than two in the bush. Or is it not?

On my part, I am uncertain about the allure of dividends. While the dividend yield of stocks is higher than interest rates of deposit accounts or even the local ten year government gilt yield, one must be mindful of possible capital loss if the risk premium demand of stocks increase. In this vein, this column had earlier warned about foolishly rushing into REIT plays in a rising interest rate environment. Indeed, what good is there to receive a 5% yield if one suffers a much larger capital loss?

Dividends are very useful as they allow the analyst to perform a very quick valuation of the company using the dividend discount model. This allows the analyst to ascertain if the counter is over or undervalued. But the dividend discount model turns on the premise that the company is able to sustain its dividend payouts in future. In this regard, it would be worthwhile to check the steadiness in the firm's cash flow generation ability. A patchy record suggests that the dividend payment may not be sustainable. Another important metric is the dividend payout ratio. A high dividend payout ratio suggests that the firm is paying out nearly all its earnings without much retained as reserves. Wouldn't it be worrying when the time comes for the firm to make capital expenditures to replace old fittings or equipment? Would it then be able to upkeep its generous dividends payouts?

Another pertinent point to note is the tradeoff between dividends and retained earnings. With higher dividend payouts, less monies is retained by the company. The return on equity (ROE) is key for deciding whether it is appropriate of the company to retain the earnings. If its ROE is in excess of 20%, it means that the company is able to reinvest the retained earnings at a return of 20% had it not distributed it to shareholders. Should the shareholder be unable to reinvest the dividends at a rate of 20%, it suggests that the shareholder is better off with the firm retaining its earnings and "reinvesting" them on shareholders' behalf because it is able to uncover more compelling opportunities. Of course, we assume that the business acumen of the management has not deserted them as the earnings are plowed back into its profitable business or equally profitable ventures. Eventually in the longer run, this should lead to capital gains.

So the bottom-line for the investor would be an assessment to find out if he or she is better off with a dividend payout to enjoy returns today or "leaving" it with a high ROE company in order to savor returns in the long run.



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