Applaud Higher Payouts to Shareholders

A recent article in the NYT derided the currently higher rate of dividends and stock buybacks, declaring that such shareholder payouts may lower growth opportunities. This points to a common misperception. Many analysts value companies based on their ability to grow earnings. At first blush, this is appropriate. However, earnings growth created without the reinvestment of earnings is much more valuable than the same earnings growth created with the reinvestment of earnings. A simple example is to take identical companies which both make $1,000,000 year after year. One company, call it the "retained earnings" company, decides to put all of its earnings into a savings account earning 5%. As a result of the investment income earned on the savings account, its next year's income is now $1,050,000. The other company, call it the "payout all earnings" company, pays out all of its earnings to shareholders as dividends. Its income stays at $1,000,000.

Analysts typically make the "retained earnings" company more valuable than the "payout all earnings" company by assigning a higher p/e ratio because of the growth in earnings. For example, they could value the "retained earnings" company, at $20,000,000 because the earnings of $1,000,000 are divided by the required return - 10%- less the growth rate - 5%, for a p/e of 20 ($1,000,000/.05). On the other hand, the "payout all earnings" company might be valued at $10,000,000 because the earnings of $1,000,000 are simply divided by the required return - 10%- less the growth rate - 0%, for a p/e of 10 ($1,000,000/.10). Here, the "retained earnings" company is worth twice as much as the "payout earnings" company! (Now visible is one reason CEOs do major acquisitions.) But is the "retained earnings" company really worth more? I think not.

There must be an adjustment made, charging a "cost" to the company for retaining the shareholder's earnings. For example, because I, as a shareholder, do not receive the funds, I could assess a "cost" to the earnings valuation by charging for my lost use of funds. Since I am paying 7.25% for money from the bank, I might charge it to the growth rate, resulting in a denominator of 12.5%, for a p/e of 8 ($1,000,000/.125) and a valuation of $8,000,000 for the "retained earnings" company. Now the "retained earnings" company is now worth 25% less than the "payout all earnings" company rather than twice as much in the earlier analysis - a significant difference.