When a company makes money, it has two main options. It can pay it back to its shareholders, or keep it to reinvest and grow the business.
In my recent 'Back to Basics' articles, I've had a look at the Price to Earnings (P/E) ratio, and discussed how it is not very meaningful on its own. I've also taken a look at the P/E to Growth ratio, the PEG, and examined how 'growth' investors use it.
When looking at the PEG, we saw that it is really only thought to work with 'growth' companies -- that is, companies that are growing their earnings faster than average for their industry. To see why that is so, we need to consider what companies ultimately do with their earnings, and what options are open to them.
Growth or dividends
If you're running a corner shop and making a profit after paying salaries (including your own), there are really two main options when it comes to deciding what to do with it.
One option would be to use it to expand the business -- perhaps put down a deposit on a second shop, or buy a vehicle to expand into home deliveries, or maybe invest it in new lines of more up-market stock.
But if you are happy with the size of your business, or see no means by which you could expand it in a way that would generate sufficient new profits, you can just take the profit out of your business and invest it elsewhere for your retirement (or spend it on fast cars, or anything else you fancy). Or you could tread a path somewhere between those two, keep some money in the business for future growth and take some out to stash away for your old age.
Those are exactly the same options open to public companies -- they can reinvest their earnings in order to grow the company, bringing greater future wealth to its investors, or pay the money back to those investors as dividends. Or, as many do, adopt a mixed approach, paying out part of it as dividends and keeping part of it to reinvest.
Investing for growth
Indicators of growth, then, really only work when a company is ploughing most of its earnings back into future growth -- the PEG relates the share price to those earnings and to expected future growth, and it pays no attention to any portion of the earnings paid out as dividends. So in pure growth terms, a company might have a high PEG, suggesting it isn't a good investment, but it might be paying out a handsome dividend instead which will more than make up for any future growth in earnings and subsequent rise in share price.
For example, Vodafone Group (LSE: VOD) has a PEG of around 2, which would place it well out of any PEG-investor's range. But it is also paying a dividend of about 6% of the share price, which is better than you'll get from any bank these days, and the shares might well be worth buying for that alone.
Who wants dividends?
I've often heard people complaining about dividends, saying "If I wanted my money back, I would have kept it in the first place". But they're missing the point that, if they invest in a company that pays good dividends, they can easily end up with considerably more money than if they kept their stash in the bank -- that 6% you can get from Vodafone beats any bank account that I'm aware of hands down.
Obviously there's a risk that a company will have a bad year and have to cut its dividend, as Marks & Spencer (LSE: MKS) has just done, but the equivalent risk with a growth company is that it will fail to hit its forecasts and you won't get the share price rise you hoped for.
What should a company do?
In an ideal world, the management of a company would be able to assess its growth potential and compare that with the returns it might give its shareholders in the form of dividends. And then, based on which would provide the best long-terms shareholder value, allocate its earnings appropriately. If a company cannot expand and grow its valuation by reinvesting its earnings, then it should be handing the cash back to shareholders so they can invest it elsewhere.
Of course, in the real world, forecasts are notoriously difficult, and managers are notoriously human. So we see companies engaging in all kinds of takeovers, mergers, and demergers in attempts (often hopeless) to appear to be actively growing their business valuation.
And we also sometimes see companies that just don't seem to be able to make up their minds. The sadly defunct GEC, for example, was notorious for sitting on mountains of cash that it didn't need for its business, but which it couldn't bear to part with by paying back in dividends to the people who actually owned it. And, even more sadly, when the company’s leadership changed back in the tech boom days, they blew it all on horribly overvalued takeovers in a futile effort to expand, and ended up bankrupting the company.
But if managers always did what was best for shareholders, and companies were easy to value as growth or dividend investments, where would the fun be?
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