Shares of Alphabet are up over ten percent today which is a very large move for a company with a ~$2 trillion market capitalization. The company announced a quarterly dividend with the initial rate set at twenty cents per share, representing a yield of less than half of one percent. The rally was not entirely due to the dividend news since earnings exceeded consensus expectations, but we can safely conclude that the dividend was viewed as a positive development by investors. This reaction mirrors the positive market sentiment after Meta introduced a dividend earlier this year.
Regular quarterly dividends have always been interpreted as a signal of a company’s long-term health. The assumption is that a company would hesitate to establish a regular quarterly dividend without having confidence in its ability to deliver on a sustained basis. There has long been a serious stigma associated with companies that cut or eliminate regular quarterly dividends.
I do not follow Alphabet or Meta closely enough to comment on whether their decisions make sense, but these developments seem like a good opportunity to revisit the question of rational capital allocation more broadly defined.
Internal Reinvestment Opportunities
Returning cash to shareholders, either via dividends or repurchases, must be viewed in light of the other options a company has for deploying free cash flow. The very best companies in the world are capable of generating high returns on incremental capital reinvested in the business.
Very few businesses are capable of generating very high returns on capital and even fewer are capable of reinvesting free cash flow at high rates on an incremental basis, at least not for very long. For example, See’s Candies is known to generate high returns on capital but has proven to be incapable of reinvesting in expansion at acceptable incremental rates of return. As a result, See’s pays dividends to its parent, Berkshire Hathaway, which reinvests its free cash flow elsewhere in the conglomerate.
If attractive reinvestment opportunities are not sufficient to absorb all of a company’s free cash flow, management must turn its attention to other possibilities. In my opinion, an important turning point in the lifecycle of a technology firm is when it begins to generate cash in excess of internal reinvestment opportunities. Alphabet and Meta are still spending heavily on growth capex but have also been returning cash via repurchases. Now they have also committed to paying regular quarterly dividends.
Acquisitions and Diversification
If the existing business cannot absorb all of a company’s free cash flow, it still might be possible for management to achieve attractive returns by investing free cash flow in acquisitions, either horizontally in the same line of business, by pursuing vertical integration of the supply chain, or in different lines of business to achieve a level of diversification. Subject to regulatory constraints, it can be advantageous to seek greater scale by acquiring competitors or, especially in the case of technology firms, acquiring companies mainly to obtain human capital that cannot be found elsewhere.
Agency problems can be an important issue when it comes to expanding a business via acquisitions. Many poorly designed executive compensation packages reward managers for achieving greater scale, usually measured in revenue growth, without subjecting that growth to any return on invested capital tests. As a result, wealth can be destroyed through unwise acquisitions pursued either to increase manager and director compensation or to fuel the giant egos common in corporate America.
Returning Capital
If internal reinvestment opportunities are insufficient and there are no acquisition candidates that make sense, management can return capital by paying down debt or returning capital to shareholders via dividends or share repurchases. For this article, I will put aside the question of how to think about optimal debt structures and focus on returning capital to shareholders.
Share repurchases represent the most efficient way to return capital to shareholders provided that shares are available for purchase at or below the company’s intrinsic value. The problem is that it is not easy to determine intrinsic value and managers are often prone to overestimating the value of their companies. Most boards are even less capable of assessing intrinsic value. Much value has been destroyed by executives who insist on repurchasing shares at high valuations.
It is all too common for managements to repurchase shares at any price in order to offset dilution caused by equity-based compensation. Some managers openly admit that they are repurchasing stock to offset dilution, which is precisely what Susan Li did a few days ago during Meta’s first quarter earnings call. The decision to issue equity-based compensation should be separate from repurchase decisions. If equity is being issued to employees above intrinsic value, there is no reason to offset dilution.
Dividends represent a taxable event for shareholders, aside from those who own shares in tax-deferred retirement accounts. In contrast, share repurchases only create taxable events for shareholders who elect to sell.1 As a result, dividends represent an inferior means of returning capital unless shares are trading above intrinsic value.
If dividends only make sense when shares are trading above intrinsic value, it follows that establishing a regular quarterly dividend cannot be the optimal capital allocation policy. A regular dividend becomes a sacrosanct part of a company’s obligations that cannot be cut without being interpreted as a negative signal regarding the company’s overall health.2 Regular dividends prevent management from shifting toward share repurchases at opportune times. In contrast, special dividends allow management to retain much more flexibility. Repurchases can occur when shares are cheap and dividends can be paid when shares are expensive.
Some investors argue that regular cash dividends represent an important form of discipline for management. Having a regular cash obligation to shareholders tends to focus the mind and keep the pressure on management to generate cash flow. While this may be true for some companies, I would argue that managers who must have their hands tied in order to act in accordance with shareholder interests do not deserve to keep their jobs. Ideally, the board should take an active role in setting compensation and dividend policy in a rational manner as circumstances warrant.
Of course, the idea that most boards are capable of this level of oversight is laughable. Too many boards are almost completely controlled by the CEO. Board seats often represent cushy sinecures paying a quarter million dollars per year, or more, to attend a few meetings. I am highly skeptical that the average board member of Fortune 500 companies even reads SEC filings and it is a fact that many own little or no stock that they have purchased independently with their own money. In such situations, cash dividends might represent a necessary palliative for terrible management and governance, but we should not confuse this with optimal capital allocation policy.
Conclusion
Dividends play an important signaling role and represent an outsized factor when it comes to investor psychology. I have encountered many otherwise intelligent people who seem to think that dividends fall from the sky like “manna from heaven” rather than represent a transfer of cash from one pocket (their interest in the company’s cash balance) to another (their personal bank account, after being diminished by taxes).
What about investors who need income from their portfolio for cash flow needs? As I wrote last year in Berkshire Hathaway as an Income Stock, there is no reason for investors requiring cash flow to restrict themselves to dividend paying stocks. If a company, such as Berkshire, retires a percentage of its stock in a year, any shareholder can sell that percentage of their own shares to manufacture a personal “dividend” without diminishing their percentage interest in the company. But psychology again comes into play. People hate to sell shares because that feels like “eating into capital” while dividends, being “manna from heaven” represent “free money.”
Every few years, I seem to write articles about capital allocation based on some event that makes less than perfect sense. It might very well make sense for Alphabet and Meta to return capital to shareholders, and cash dividends could make more sense than repurchases at current valuations. Of course, these managements are pursuing both dividend and repurchase programs at the same time, muddling the question.
But they are no worse than most other public companies. I almost never read about capital allocation along the lines of what I’ve written in this article. Perhaps my annoyance is an inevitable effect of owning shares of Berkshire Hathaway for many decades. I know that capital allocation at Berkshire is handled in a rational manner and that a future dividend will occur for the right reasons. My hope that other companies will follow a similar policy inevitably leads to frustration.
Most investors view initiation of a dividend and dividend increases as “good news” and dividend cuts as “bad news” but, in all too many cases, such announcements simply represent incoherent thinking on the part of managements and boards.
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- The 1% share repurchase tax, introduced in 2023, has not been a major impediment for repurchases so far, although the President has proposed a quadrupling of this tax. Logically, there should be no repurchase tax at all since capital gains taxes on sales are owed by selling shareholders. The political claim that companies can “avoid taxes” by repurchasing shares rather than paying dividends has no basis in fact. [↩]
- Although it is unusual, some companies formally designate dividends as fixed obligations in non-GAAP presentations. For example, Union Pacific’s measure of “free cash flow” is stated after dividend payments to shareholders. In other words, management considers dividends so sacrosanct that they are totally off limits from a capital allocation standpoint. Even for a mature business like Union Pacific, this does not make very much sense. [↩]