The ultimate destination for any successful enterprise is to become a dividend machine. If a company never reaches a stage where it can sustain a regular flow of cash to its owners, should it choose to do so, then it represents a total failure from a capital investment standpoint.
A company may create jobs and provide products that customers desire, at least for a time, but if money only ever goes in and nothing ever comes out, the enterprise represents the very antithesis of investing. It is just a black hole for precious capital.
Sure, there is usually the ability to sell your ownership to a would-be shareholder, and hopefully at a higher price than what you paid for it, but any rational buyer would need to have confidence that a cash dividend will be forthcoming at some stage. Without the eventual promise of a future cash reward, the company is worthless beyond what you can flip it to some sucker for.
It is not a particularly insightful idea. Considering what goes in versus what goes out is the philosophical underpinning for concepts like discounted cash flow analysis, return on equity, and internal rates of return. But it is easy to overlook when share prices absorb so much of our attention.
Although it’s not obvious, Berkshire Hathaway is actually a good demonstration of the idea. Buffett’s firm has famously avoided distributing cash to shareholders since the get-go, and still its market value has climbed more than 50,000x over that period. While this might seem to disprove the necessity of dividends to investors, all it actually illustrates is the power of prudent capital management and allocation. Masters of the craft like Buffett and Munger chose to sacrifice immediate gratification for the sake of much larger potential distributions in the future.
It is rare in how long that particular flywheel has managed to keep spinning, but the point was never to avoid paying out cash. It was only to hold it back until it made sense to do so. Had they paid out a large chunk of the unencumbered cash along the way, Berkshire would no doubt still be successful and have provided a good return to investors. It just would not have been nearly as good as it has turned out to be.
The company did not avoid dividends because it could not pay them; it deferred them because they bet (correctly) they could use that capital to generate a better rate of return than what shareholders could likely achieve elsewhere.
If Berkshire were to begin distributing its free cash flow today, it could likely sustain annual payments of roughly US$30 billion. It could actually pay a lot more if they wanted to tap into their vast hoards of cash from previous years. But they do not. Not yet. Nevertheless, the value of the business remains predicated entirely on what it could pay out, if and when it chooses to do so.
And it should, the moment the prospect for attractive reinvestment is no longer superior than what can be attained elsewhere with comparable risk.
As Buffett himself has said before, there are only two main considerations for a responsible board when considering whether or not to pay a dividend. First, and most obviously, there must be cash available to distribute without risking the solvency or viability of the business. Second, they must determine if there are any compelling investment opportunities where that cash could be deployed for a high return, and in a manner that shareholders could not access outside of the company itself.
If the answer to the first is yes and the second is no, the only sane course of action is to pay a dividend. Alternatively, if the shares are trading below a reasonable estimate of fair value, a share buyback serves a similar purpose by increasing the proportional claim of each remaining share on those future dividends, which is something Berkshire has done before.
Many companies can answer the first question affirmatively, but a great number falter on the second. Hubris, ego, and misguided hope often lead management to retain cash only to waste it on poor acquisitions or inefficient projects. Indeed, you could argue that a small dividend has value in restraining over-zealous ambitions.
The real business superstars are those that generate massive excess cash and can reinvest it to create a compounding machine of ever-higher cash flows. This is a process that should be allowed to run as long as possible, right up until the point where the company can no longer reinvest at an attractive, risk-adjusted rate.
Berkshire is arguably approaching this stage. And when it finally flips the switch, more cash will gush out than the founders of a small textile mill could have ever conceived. It will be a new chapter for the business, perhaps a less exciting one and certainly one marked by an inevitable slowdown in growth. But far from being a sign of defeat or a lack of ambition, it will be the ultimate validation of its success.
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