How Dividends Destroy Shareholder Value

Most CEOs Squander Corporate Capital, Only A Select Few Play Their Hand Well

• Was dividend policy behind the extraordinary 60 year performance of Berkshire Hathaway?

• How did dividends contribute to the declining fortunes of Intel?

• Were dividends to blame for a decade of stagnation at McDonalds?

• How did dividends knock Microsoft out of contention in the search and online advertising markets?

• What surprising lesson can we learn from the Federal Republic of Germany about dividend policy?

• How did exemplary CEOs including J.D. Rockefeller, John Malone, Henry Singleton, Warren Buffett and Jeff Bezos view dividends?

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This is a very long post, but well worth the read. It is Chapter 30, verbatim, reproduced from the book ‘Fabric Of Success: The Golden Threads Running Through The Tapestry Of Every Great Business’ [ISBN 979-8325862762] with the consent of the author.

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Imagine this: during your investment research, you come across two nearly identical companies. They're in the same industry, targeting an enormous market, and offering strikingly similar products. Both are led by exceptional management teams, operating at peak efficiency, and delivering an impressive 20% return on invested capital (ROIC). The only notable difference? Company B pays a dividend with a 50% payout ratio, while Company A keeps all its earnings and offers no dividend.

Now, here’s the question: which one would you choose to invest in—Company A or Company B?

Take a moment to ponder this. The answer will almost certainly surprise you… all will be revealed shortly.

Chapter 30. Dividends & Retained Earnings

One of a CEO's most critical responsibilities is capital allocation, yet it's an area where many struggle. CEOs often make suboptimal decisions without fully understanding their consequences. A prime example of this is dividend payments. Many CEOs feel obligated to issue dividends, unaware that this practice can actually be detrimental to their company's growth and long-term success.

Compounding this issue is the widespread myth that a large part of an investor's return on equities stems from reinvesting dividends. This misconception leads shareholders to demand dividends, unaware that there is a fundamental flaw in their logic.

In combination, these two factors have caused many companies to fall short of realizing their full potential.

Capital allocation decisions should be guided by careful consideration of opportunity costs. A business is subject to a large number of outside influences and the vast majority of them can’t be predicted. This is why Henry Singleton preached about remaining flexible. He said that he deliberately avoided making plans and instead would steer the boat each day based on prevailing circumstances.

That’s the right way to run a business, yet most CEOs default to blindly following a play-book, regardless of circumstances, without any critical thinking. They effectively replace management discretion with a codified approach that avoids the need to make difficult decisions.

Do you want someone like that running a company in which you’re invested?

As we’ll come to discover, Singleton didn’t pay dividends. Neither do Warren Buffett or Jeff Bezos. The question therefore becomes, “why not?” Answering this question is the subject matter of this chapter.

In 1972, the ‘Nifty Fifty’ - a group of 50 top-performing U.S. stocks including McDonald's, Coca-Cola, Walt Disney, American Express, Gillette, and General Electric -were heralded as the best investment opportunities. Half a century later, many of these companies remain industry leaders. An investor who evenly distributed $5,000 across all 50 companies in 1972 and held them until the end of 2022 would have seen their investment grow at a compounded annual rate of 10.08%, turning $5,000 into $609,020 through a combination of capital growth and dividends.

However, rather than spreading their investment across the Nifty Fifty, that investor could have chosen to put the entire $5,000 in Warren Buffett’s business, Berkshire Hathaway. Back in 1972, Berkshire Hathaway was a turnaround situation emerging out of a failed textile business and it was not considered worthy of being included in the Nifty Fifty. that £5,000 would have grown to an incredible $28.7 million.

This demonstrates the magic that Buffett discovered early on in his career – the extraordinary power of compounding retained earnings. Buffett achieved an astonishing annualized return of 18.9%, while the Nifty Fifty compounded at a rate of 10.08%. The key, is optimizing growth by avoiding the payment of dividends.

It's not rocket science—just basic mathematics. Consider this: if a company earns a 20% return on capital and reinvests everything back into the business, its value will compound at close to a 20% rate. However, if the company pays out 50% of its earnings as dividends, the compounded growth rate is slashed in half, closer to 10%.

Let’s explore the mathematics (please stay with me, this is easy to follow).

Believe it or not, if you have a penny and double it every day, by the end of the month on the 30^th day, that penny would have grown to be worth over $5.3 million!

This is calculated with the following formula:

V_n=V₁×2⁽ⁿ⁻¹⁾

where:

n is the number of days

V_n is the final value

V₁ is the starting value

For 30 days the formula becomes:

V₃₀=0.01×2⁽²⁹⁾=5,368,709.12

So, by day 30, a penny that doubles every day will have grown to be worth $5,368,709.12

This scenario represents ‘Company A’ generating 100% return on invested capital and reinvesting all of its earnings to optimize compounding and exponential growth.

Now let’s explore a second scenario representing ‘Company B’ which enjoys the same 100% return on invested capital, but which distributes half of its earnings every time it doubles.

If each day the balance doubles, and 50% of the gain (i.e. the additional amount earned from the doubling) is taken away, the formula becomes:

V_n​= V₁​×(1.5⁽ⁿ⁻¹⁾)

For 30 days the formula becomes:

V_n​= 0.01​×(1.5⁽²⁹⁾)=1,278.34

By day 30, solely because of the regular deductions of capital being compounded, the penny will have grown to be worth only $1,278.34. Quite a stark difference.

But let’s not forget the value of the sum that had been deducted.

And the sum of monies taken away over the 30 days is:

By day 30, the part of the gain removed each day would sum to $1,278.33 (this represents an equal gain to that accumulated by the doubling activity but does not include the initial penny, hence the 0.01 difference). So collectively, the compounded growth and distributions of half the earnings, sum to $2,556.67.

The only difference between these two scenarios, one yielding a return of $5.3 million and the other only a couple of thousand dollars, is the regular distribution of some of the earnings. Both started with the same capital and both enjoyed the ability to generate the same return on invested capital. Disrupting exponential growth over time results has a very dramatic effect on the outcome. This demonstrates the power of compounding versus the impact of a regular distribution in the form of a dividend.

But the story doesn’t end there. Thanks to its consistently higher growth rate, the market would assign Company A a far greater earnings multiple for valuation purposes. If Company A is valued at 18 times earnings, while Company B commands an 10 times multiple, the difference in market capitalization becomes staggering.

Because earnings flow from a doubling of capital each day, we know that on the final day, Company A generated $2.68 million in earnings while Company B only generated $1,278.

Let’s assume that the doubling happened annually rather than daily, because valuation multiples are applied to annual earnings. Using their respective valuation multiples, Company A would be capitalized at $96.6 million, while Company B would be capitalized at only $12,780. Company A is worth 7,559x more than its dividend-paying counterpart. That’s how much damage dividends can do!

This explains why Buffett doesn’t pay dividends and why Berkshire Hathaway outperformed the Nifty Fifty by a factor of 47x over a 50 year period.

Berkshire Hathaway did, in fact, pay a dividend once, but only once. Warren Buffett quickly realized it was a mistake. The dividend, issued on January 3, 1967, was just 10 cents per share, representing a modest 0.56% yield when the stock was trading at $17.87. This payout led to a total distribution of $101,755 from the company's balance sheet to shareholders. Had that money been reinvested in the business, it would have grown to over $3.1 billion by 2023.

Berkshire Hathaway 40 year valuations, with and without dividends

The chart above illustrates the growth of Berkshire Hathaway’s market capitalization from 1977 to 2017. One line represents the actual performance, while the other depicts the growth had the company paid out 50% of its earnings as dividends, retaining only the other 50%. This comparison explains why Buffett was right not to repeat that 1967 dividend.

Albert Einstein famously referred to compounding as the "8th wonder of the world," saying, “He who understands it, earns it.”

Those that don’t get it not only underperform, but also allow competitors to capture the market share which remains unclaimed due to the slower growth rate of their business.

The dividend-focused mentality is rooted in economic history. Prior to the 1950s, there was a prevailing belief that a company generating regular cash for its investors signaled its quality and reliability as a business. During that era, companies were heavy with tangible assets, meaning that organic growth was slow. Acquisitions were rare and share repurchases were not yet a thing, so with excess capital accumulating, returning it to shareholders became the default choice.

Today we live in a different world. Many of the leading companies have an intangible asset base which is easy to scale, mergers and acquisitions are now common, and share-buybacks done properly are incredibly accretive to shareholder returns. But despite changing times, so many CEOs are still using their grandfather’s play-book.

The debate about whether or not to pay dividends isn’t new. In the 1870s, Sam Andrews, a director at Standard Oil, believed that consistently high dividend payouts would make Standard Oil's stock an attractive investment. J.D. Rockefeller disagreed, arguing that profits should be reinvested to fuel growth and strengthen the company’s competitive position.

This disagreement was a source of ongoing tension within Standard Oil. It culminated in Andrews being ousted from the business. Rockefeller went on to become the richest man on the planet and his approach was validated by Standard Oil’s subsequent enormous success.

John Malone is another important character featuring in the history of dividends and capital allocation. He served as CEO of TCI (Tele-Communications Inc) from 1973 until 1999. It’s important to understand that the prevailing trend among public companies at that time was to focus on the optimization of net earnings. To be honest, that mindset continues today, but Malone recognized that this approach was fundamentally flawed.

Malone recognized that pre-tax earnings led to taxes, which drained capital from the company. Malone asked himself, ‘Why bleed capital to the tax man when instead it can be reinvested in a tax efficient manner that will compound for the benefit of the business and its shareholders?’ This approach meant no dividends, but under Malone’s leadership TCI became a financial powerhouse, delivering a remarkable compound annual return for shareholders of 30.3%. Every dollar invested in TCI at the beginning of his reign, grew to be $900 by the time he stood down. Comparatively, the S&P500, comprising companies mostly fixated on maximizing quarterly earnings and favouring dividends over reinvestment, turned the same invested dollar into only $22 over the same 25-year period.

Malone created a headache for Wall Street analysts. They struggled with his approach. They had always valued businesses on earnings multiples, and so for them optimizing earnings was the holy grail. Malone tried to help them through their malaise. He emphasized that in evaluating a business they ought to divert their attention away from short-term bottom line earnings and instead focus on the ‘earnings-power’ of the business. He argued that reinvested capital is not a cost of running the business, it’s the means by which a company optimizes future cash flows, which is where the real value of a business lies. Reinvested capital reduces bottom line earnings, which makes net earnings an unreliable indicator of the true worth of the business. Instead, the important metric is how much cash the business is capable of generating in the absence of reinvestment. Accordingly, Malone advocated that analysts ought to look further up the income statement as this reveals the true earnings-power of the business - this is how John Malone introduced the now ubiquitous term ‘EBITDA’ into the business lexicon back in the 1970s.

Unfortunately, EBITDA is used for all sorts of nefarious purposes today which is why Charlie Munger referred to it as ‘bullshit earnings’, but its purpose is entirely legitimate if used properly.

Just like Singleton, Buffett and Bezos, Malone understood that the true intrinsic value of a business lies in the net present value of future cash flows, not current earnings.

In Amazon’s 1997 inaugural shareholder letter, Bezos emphasized that his was a long-term approach, prioritizing future cash flows over short-term Wall Street earnings expectations. This strategy, combined with his refusal to bleed capital in the form of dividends saw Amazon’s market cap grow from $438 million in 1997 to $1.7 trillion by the time Bezos stepped down as CEO in 2021, reflecting an astounding 43% compound annual growth rate.

Wall Street analysts continue to struggle in comprehending the brilliance of this approach. Using earnings to value a company such as Amazon, as many analysts still do, will lead to entirely the wrong conclusion about the company. Earnings per share will be low and the earnings multiple will appear unattractively high, deterring many from investing. This explains why so many people missed one of the best investment opportunities of the past century!

A really interesting aspect of this story is the lesson to be learned the Federal Republic of Germany. After World War II, the German economy was in ruins. In 1947 industrial output was only one-third of its 1938 level and a large percentage of Germany's working-age men had been killed in battle. Nevertheless, 20 years later, Germany's economy had become the envy of the world. It was referred to as the 'German economic miracle' and it has remained as Europe’s strongest economy consistently since 1980, even before the reunification of East and West Germany. The relevance to us, is in how it was achieved.

Germany introduced a 95% corporate tax rate. It’s not clear whether this was done to raise public money to be used to rebuild Germany or whether it was devised by an economic genius who was thinking about second and third level consequences of the policy, but it worked out well. Think about how a 95% tax rate might influence corporate behaviour. Why maximize earnings, when almost all of it will be taken in tax? So companies sought to minimize earnings by reinvesting heavily in growth. With little or no corporate earnings, investors were neither motivated nor distracted by dividend income and this approach led to rapid economic expansion – the ‘German economic miracle’.

Germany achieved great success in exactly the same way that Berkshire Hathaway, Amazon and TCI achieved their own economic miracles. It’s all about taking a long term view, preserving corporate capital, reinvesting in the business and enjoying the power of compound growth over decades.

A stark example of what happens when a great company deviates from this approach is the unfortunate case of Intel.

Once a dominant force in the semiconductor industry, Intel was renowned for its innovative microprocessors and leadership in technology. However, a shift in management strategy led to a significant decline in its competitive edge. This downturn can largely be attributed to former CEO Brian Krzanich, who prioritized short-term financial metrics over long-term growth. Krzanich's remuneration package, which focused on earnings performance, drove him to make decisions that favored immediate financial gains. To boost earnings per share (EPS), he cut operating expenses, most notably in research and development (R&D), a move that starkly contrasted with Intel's legacy of innovation. Despite the importance of Moore’s Law, which emphasized the rapid doubling of transistors in integrated circuits, Krzanich redirected resources away from R&D and toward stock buybacks, inflating EPS at the expense of the company’s future.

In addition to slashing R&D, Krzanich delayed transitioning to more advanced manufacturing processes in an effort to reduce capital expenditures. This allowed competitors like TSMC and Samsung to surpass Intel in manufacturing technology, eroding its market leadership. The lack of innovation and ambition led to a talent drain, as key engineers left to work at Intel’s more forward-looking rivals.

Further compounding these errors, and pertinent to this narrative, Intel adopted a progressive dividend policy during Krzanich's tenure, consistently increasing dividends sequentially even as the company’s fortunes declined. This meant that capital which ought to have been reinvested was being handed out to shareholders impairing Intel's ability to compete.

By 2024, Intel's market capitalization had dropped to $84 billion, down from $108 billion when Krzanich first took over, marking a disastrous period for the company. Intel now has a new CEO, Pat Gelsinger, who has been scaling back dividends and refocusing on long-term strategy, but whether the company can fully recover remains uncertain. The damage has been done.

To further illustrate how the payment of dividends negatively impact a business, consider the contrasting strategies of Publix and McDonald’s.

Publix Super Markets, founded in 1930, is seen as a challenger to Wal-Mart in its domestic market, particularly in Southern States. It owes its phenomenal growth to the power of retained earnings rather than bleeding capital in the form of dividends. Ed Crenshaw, CEO and grandson of founder George Jenkins affirmed that:

‘Profits were the fuel for rapid expansion. It was years before we ever declared a dividend.’

Ed Crenshaw

Had Publix opted to pay dividends from the outset, it couldn’t have grown as quickly as it did and it wouldn’t have been as successful as it has been. Shareholders may have received regular income, but the investment would have resembled a high-yield bond rather than a growth-oriented equity.

In stark contrast, in recent years McDonald’s took the high-yield bond approach, much to its detriment. Quarterly revenues in 2024 are at the same level as they were in 2010. Why? During this period, McDonald’s dividend payout ratio had been as high as 80 percent – cause and effect.

If Publix is a thoroughbred race horse nurtured for high performance, McDonald’s is a cow that has been milked to the point of exhaustion through the payment of dividends.

Investors have various asset choices for investment, with corporate assets typically divided into two categories: equity (stocks) and fixed income (bonds). These categories represent two fundamentally different approaches to investment: taking an ownership stake in a business or providing it with debt. The choice is subjective, largely a function of the investor’s circumstances and attitude toward bearing risk.

An equity investor puts capital at risk without any guaranteed return; however, if the business succeeds and profits grow, the investor is entitled to a share of that success. As profitability rises, so does the value of the investor’s stake. But there are no assurances, and the investor risks losing value if the business falters. The emphasis here is on optimizing the economic success of the business and so all corporate decisions should be made with this objective front of mind.

In stark contrast, a debt investor has a contractual relationship with the company. Provided the business meets its repayment obligations, the investor is assured of receiving the principal plus fixed interest payments - hence the term "fixed income." This investment outcome is more predictable and quantifiable if held to maturity.

Stocks and bonds are entirely different because ownership and lending have nothing in common. This isn’t a difference in degree; it’s a difference in kind. Expecting a steady income stream from an equity investment is entirely unreasonable. A responsible CEO should resist such expectations by avoiding rigid dividend policies that imply fixed returns on what is, by nature, a variable asset.

Many corporate boards argue that they must pay dividends because a significant number of their investors require income. However, this reasoning is flawed on two counts: first, it misunderstands the real issue, and second it proposes an ineffective solution.

'Whenever a theory appears to you as the only possible one, take this as a sign that you have neither understood the theory nor the problem which it was intended to solve.’

Karl Popper

While some investors require income, many others others do not and would prefer to optimize capital growth. Why should a company favour one group of investors over another? Additionally, why should the company dictate the timing and amount of cash distributed to investors? Not all shareholders have the same needs at the same time.

It is an undeniable truth that dividends attempt to provide a one-size-fits-all solution, which is inherently impossible. Ironically, not paying a dividend actually offers the flexibility to meet the needs of all shareholders. Through the liquidity of the stock market, those who need income can choose if, when and how much cash to drawdown from their investment instead of relying on a dividend. If the amount withdrawn is less than the growth rate of the business, the capital value of their investment will still continue to grow, but if they drawdown large sums which causes the value of their investment to stagnate, it is without prejudice to the growth aspirations of other shareholders. This approach allows shareholders to manage their income streams more efficiently and to better control the timing of their cash flows to mitigate personal tax liabilities. Warren Buffett has always advocated for this approach when questioned about why he refuses to pay a dividend.

In essence, the company doesn’t need to partially liquidate its assets to pay a dividend. Instead, investors can decide when and how much of their own equity stake to liquidate, without negatively impacting other shareholders.

Another common argument from corporate boards is that dividends are necessary to attract institutional investors. It is certainly true that pension funds and the like do favour dividend-yielding stocks for income generation and liability-matching purposes. However, income-chasing investors are not the ideal shareholders a company should seek to attract. They tend to prioritize their own commercial objectives and often switch investments based on prevailing dividend yields, showing little commitment to the long-term goals of the business. Allowing self serving shareholders such as these to influence capital allocation decisions reflects poor management judgment.

In 2008, Microsoft explored acquiring Yahoo in a deal valued at over $44 billion, but the acquisition ultimately fell through for various reasons. Pressured by income-seeking shareholders, Microsoft distributed the capital earmarked for the deal as dividends instead. This decision prevented Microsoft from using the funds for another strategic acquisition or reinvesting in its own search technology development. As a result, the company struggled to compete in the search and online advertising markets, where Google came to dominate. Crucially, many of the shareholders who benefited from the dividend windfall soon exited. They had no interest in the long-term prosperity of the business, viewing it purely as an opportunistic source of short-term income.

This highlights the danger of allowing investors to shape management decisions, rather than the other way around. Microsoft allowed the tail to wag the dog, much to its detriment.

A company will always have shareholders—this is a given in the stock market because for every seller there is a buyer. The real challenge lies in attracting the correct type of shareholders, those aligned with the company’s long-term objectives.

‘Run the company well, allocate capital intelligently and the business will attract the shareholders that it deserves.’

Charlie Munger

Companies like Berkshire Hathaway and Amazon, despite not paying dividends, have never struggled to attract institutional investors. While some might argue that their size and prominence afford them a unique status, it’s important to remember that both companies started small and achieved their success without paying dividends from the outset.

Henry Singleton was another outstanding CEO who resisted paying dividends. When questioned on the matter, he responded, "What would the stockholder do with the money? Spend it? Teledyne is not an income stock. Reinvest it? Since Teledyne earns 33 percent on equity, we can reinvest it better for them than they could for themselves. Besides, the profits have already been taxed—paid out as dividends, they get taxed a second time. Why subject the stockholder’s money to double taxation?"

Singleton shifts the debate to the investor's viewpoint, highlighting the numerous disadvantages of receiving dividends. He emphasizes the issue of double taxation, which is significant. Consider this: a dollar of pre-tax earnings is first reduced to 75 cents after a 25% corporate tax. If that 75 cents is paid out as a dividend, it might be subjected to a 40% income tax, leaving the investor with just 45 cents of the initial dollar. The tax man pockets the other 55 cents, which is more than the investor receives! But it doesn’t end there. That money needs to be reinvested and after factoring in market spreads and transaction fees, in an illiquid security the investor might end with no more than 38 cents of the original dollar reinvested. In this scenario, the only real beneficiaries are the tax authorities and stockbrokers. Why would any investor favour such an outcome?

If, instead, the company had optimized reinvestment and minimized taxable earnings, almost all of that original dollar could have been reinvested to accelerate future compound growth. It becomes obvious which is the better approach.

There is a prevailing myth that the lions share of an investors returns flow from the reinvestment of dividends. But let’s think about this mathematically. Dividends are reinvested by investors at market prices – often a multiple of book value – while retained earnings are reinvested by a company at book value. This distinction is so important. So what does it mean? Essentially, all else being equal, the return on retained earnings that are reinvested in the business will be the same as the return on equity being achieved by the business, rather than being only a fraction of that number if paid out to the shareholder and reinvested at premium prices via the stock market. So the company is able to reinvest on behalf of its shareholders at a preferential price and, in reality, it's the reinvestment of the retained earnings, not dividends, that drives exceptional shareholder returns.

As discussed earlier, a company is capable of compounding in value. This is what makes equity investing so attractive. By reinvesting earnings it becomes possible to create a tax-efficient long-term cycle of capital growth. Investors preferring income over capital growth should, with few exceptions, be active in other asset classes.

From a shareholders perspective, another point to consider is the administrative burden of reclaiming withholding taxes on dividends paid by companies in foreign jurisdictions—a process that can be difficult, if not impossible. This is yet another reason to view dividends unfavourably.

Let us now consider dividends through an entirely different lens.

If a business becomes unsustainable or no longer economically viable, it will wind down operations, pay off debts, and distribute the remaining assets to shareholders. This is known as liquidation of the business assets.

Similarly, if the return on marginal capital declines, the logical strategy might be to shrink the balance sheet, thereby reducing the business's capital base back to a profitable core. This is effectively a ‘partial liquidation’ of the business, where only some of the company's assets are distributed to shareholders.

Now ask yourself this: Is the payment of a dividend not a partial distribution of the company’s accumulated asset base? Are the terms ‘partial liquidation’ and ‘dividend’ not entirely synonymous?

They both refer to the same process. Both involve the reduction of a company’s net assets, weakening the balance sheet, and decreasing the capital deployed by the business.

By way of example, consider the tobacco industry which is in long-term decline. Companies in this sector are reducing their asset base, quite rightly, through large dividend payouts. They are partially liquidating their business and returning shareholder capital that can no longer be utilized productively. These are the types of companies that are able to justify the payments of dividends because all other capital allocation options have been exhausted.

Why would a company with opportunity to grow, intentionally shrink its asset base through the payment of dividends? Why partially liquidate a business with good growth prospects?

To make matters worse, some CEOs deplete cash reserves by paying dividends and then turn to debt or equity markets to raise growth capital. This approach weakens the balance sheet, increases funding costs, and dilutes existing shareholders, all for the sake of maintaining dividend payments. This strategy is not only irrational but verges on incompetence. The equivalent scenario is when dividends are prioritized over repaying debt or reducing the share count, which amounts to much the same thing.

Many CEOs would not have previously contemplated dividends in these terms before, but they would be well advised to do so in future. This shift in perspective could lead to more coherent capital allocation strategies.

The capital allocation process for the most successful companies is structured like a waterfall, with decisions made in a specific order of priority. First, the company focuses on reinvesting in the business or building a cash reserve for future investments. If no profitable reinvestment opportunities are foreseen, the next step is to consider reducing debt or repurchasing undervalued equity, both of which benefit the business and its shareholders. Only when all of these options have been exhausted and cash reserves accumulate to the point of excess should a company consider distributing surplus capital as dividends. This implies that return of capital to shareholders will mostly be an ad-hoc activity, paid as a special dividend.

Let’s explore each layer of this capital allocation waterfall more closely.

Even when a company has no immediate use for surplus cash, building a cash reserve in anticipation of future opportunities is a valid reason to refrain from paying dividends. A cash war chest provides flexibility for strategic initiatives and maintains the ability to weather economic downturns. Berkshire Hathaway has built a cash war chest of over $250 billion and still has no intention to pay dividends. Crucially, shareholders have confidence that it will be put to good use and so don’t demand a dividend. Buffett explains, “We have no interest in cash except to the extent it gives us opportunities. The only reason for having cash is if you think you’re going to need it… Cash combined with courage in a time of crisis is priceless.”

The next level of the waterfall involves considerations around debt and equity financing. Share repurchases are a huge topic dealt with in a separate chapter. However, it is important to briefly touch on them here. Debt is typically a cheaper form of financing because lenders face lower risks, with repayments scheduled at regular intervals and they have a senior claim on assets in case of insolvency. On the other hand, equity financing involves offering investors a stake in the business's future success, leading to perpetual dilution of earnings on a per-share basis and of the capital value of the business across a broader base of owners. This arguably makes equity financing less desirable.

Yet, many companies focus on paying down debt while showing less urgency in reducing the more expensive and less desirable equity financing. The situation becomes even more puzzling if one considers that a dividend is a one-time payment to investors, while reducing the share count through buybacks would provide remaining shareholders with a larger share of all future earnings and capital appreciation, benefiting them in perpetuity.

There is also a paradox to consider. A CEO will spend a significant amount of time presenting to investors in person, by video link and through publishing written reports. The aim is to retain existing investors and to attract new ones. In this context, it seems contradictory for a company to promote itself as a sound investment when it has opted to distribute capital rather than investing in itself through buy-backs.

One more factor to consider in this layer of the waterfall is that public companies often trade below their intrinsic value for an extended period of time. Some CEOs feel powerless in this situation and accept that the market may permanently undervalue their company. However, strategic CEOs like Warren Buffett and Henry Singleton see this as an opportunity to repurchase their shares as a discount – a ‘SALE’ event is happening in the market and it’s time to fill our shopping trolley!

In 2018, Berkshire Hathaway revised its share repurchase policy, giving Buffett flexibility to buy back shares whenever undervalued. When the stock market crashed in March 2020 due to the Covid pandemic and Berkshire’s stock fell sharply, Buffett took advantage of the situation, repurchasing $37.3 billion worth of shares over the next 12 months. This move not only helped the share price recover, but also allowed Buffett to capture huge amounts of value for his remaining shareholders. He halted buybacks in 2022 when the stock no longer traded at a discount, and two years after that the shares were up 300% from their recent low. Had Buffett routinely distributed surplus capital through dividends, this strategy would never have been possible (share repurchases are discussed in more detail in the next chapter).

Buffett, Bezos, Singleton, and Malone never exhausted their primary options for accretive capital allocation, so they were never in a position where distributing assets as dividends made sense; they never reached the bottom of the waterfall.

So how should a CEO think about whether or not earnings should be retained?

‘…earnings should be retained only when there is a reasonable prospect backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future, that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produced incremental earnings equal to, or above, those generally available to investors’

Warren Buffett

Buffett’s idea that ‘every dollar retained by the corporation should create at least one dollar of market value for owners’ is often misunderstood. Many view this through the lens of retained earnings being multiplied by a company’s book value. The assumption is that if a company trades at a multiple of book value, retaining $1 will increase market capitalization by more than $1. For example, if a company trades at twice its book value, retaining $1 would supposedly add $2 to market cap.

However, this way of thinking is completely upside down and incorrect. If retained earnings do not enhance profitability and instead sit idle as cash, the market will view the company as inefficient, lowering its price-to-book ratio and creating no added value for shareholders

The proper interpretation of Buffett's wisdom is to test whether or not the present value of the incremental future cash flows from the retained earnings exceeds the sum retained. The emphasis is on ensuring that the retained earnings contribute substantively to the enduring value of the business.

This brings us to the second part of Buffett's test: ‘This will happen only if the capital retained produces incremental earnings equal to, or greater than, those generally available to investors.’ The implication is that a company should retain earnings only when a dollar reinvested in the business yields more value than a dollar in the hands of shareholders. Typically, this is true due to the double taxation of dividends and the frictional costs associated with reinvesting them, as discussed earlier. However, there are cases where paying dividends may be more favourable for investors, such as when a company operates in a declining industry and cannot allocate capital effectively within the business. Still, these situations are exceptions rather than the norm.

To conclude this chapter, let us consider the words of Mark Leonard, another exemplary CEO, who wrote in his 2021 Constellation Software shareholder letter, "One of our directors has been calling me irresponsible for years. His thesis goes like this: CSI can invest capital more effectively than the vast majority of CSI's shareholders, hence we should stop paying dividends and invest all of the cash that we produce… Historically, we have paid three special dividends, and for the last decade, we have also paid a regular quarterly dividend. I have stopped arguing. I have converted, and with the fervour of the newly converted, I am busy demonstrating my newfound faith."

Eventually, all of the highest performing CEOs see the light and converge on a similar approach to capital allocation and dividend policy. This is no coincidence, it’s a golden thread that runs through all great businesses.

Ultimately, companies that pay dividends typically either lack viable reinvestment opportunities, possibly due to operating in a declining industry, or else have management that lacks the creativity and financial acumen to fully realize their company's full potential.

This is why many top-performing investors view a company's dividend policy as a key indicator of its quality as an investment.

Have you changed your opinion on dividends?

Perhaps you now think that the companies in which you are invested should cease paying dividends?

Feel free to forward a copy of this post to the CEO of any company who you believe would benefit from reading it.

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NOTE: This post is a chapter from the book Fabric of Success, republished with the permission of the author. The book also explores the intricacies of share repurchases, stock-based compensation, and many other critical aspects of corporate management that equity investors should consider.

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