As our clients know we at CH Financial spend a great deal of time talking about the free cash flow within our investments. We do this because history has taught us that many of the best long term investment ideas come from finding industries and companies that are not just profitable, but also generate solid long term cash driven income streams that can be used to reward those who invest in them. For many of the companies our portfolio managers buy, this reward comes in the form of dividends.
Put simply, dividends are paid from the after-tax income earned by a company. Since dividends are often paid out as cash to shareholders, those profits can offer a reasonable window into the true profitability of a company. The focus of this article is on how these dividends can help to smooth out the volatility in our clients’ portfolios and provide the income they need in challenging economic times.
Cash Flow vs. Profits
When dividends are paid out to shareholders their sustainability is dependent more on the free cash flow of a company rather than just the company’s profitability. The following example can help to illustrate the point:
Company A has revenues of $1.0 billion and expenses of $900 million. The net profit of the company would be $100 million. But the picture may not be quite so simple. Let’s say that of the $1.0 billion in revenue $400 million is reported as accounts receivable, meaning the cash has not yet been received. This could mean that although Company A is profitable, it may be experiencing a shortage of cash on hand, which may present a risk to the company. What if they have trouble collecting the money owed to them? The company may need to borrow just to cover short term immediate expenses like payroll.
Company B, by contrast, makes the same $1.0 billion in sales and $900 million in expenses but all their sales are cash based so they have no receivables. This company would not only have $100 million of profit, but they would also have this money in the bank to cover both future expenses and to pay out dividends to their shareholders. This is what we mean by true free cash flow.
Rising Dividends
A company that is growing may maintain its dividend or it may even increase it, making it even more attractive for investors. Let’s take a look at a company that grows its dividend by 10% per year for ten years.
| Year | Share Value | Dividend Rate | Dividend |
|---|---|---|---|
| 1 | $100.00 | 3.0% | $3.00 |
| 2 | $100.00 | 3.3% | $3.30 |
| 3 | $100.00 | 3.6% | $3.63 |
| 4 | $100.00 | 4.0% | $3.99 |
| 5 | $100.00 | 4.4% | $4.39 |
| 6 | $100.00 | 4.8% | $4.83 |
| 7 | $100.00 | 5.3% | $5.31 |
| 8 | $100.00 | 5.8% | $5.85 |
| 9 | $100.00 | 6.4% | $6.43 |
| 10 | $100.00 | 7.1% | $7.07 |
| Total Dividends | $47.81 |
In this example we can see that the shareholder earned just under 50% on her investment within ten years. Even if the price of the stock remained flat through the entire period, the shareholder would be earning over 7% per year after ten years.
Reinvesting Rising Dividends
Now consider the same example if the shareholder reinvested the dividend into more shares (as is typically the case with mutual funds):
| Year | Share Value | Dividend Rate | Dividend |
|---|---|---|---|
| 1 | $100.00 | 3.0% | $3.00 |
| 2 | $103.00 | 3.3% | $3.40 |
| 3 | $106.40 | 3.6% | $3.86 |
| 4 | $110.26 | 4.0% | $4.40 |
| 5 | $114.66 | 4.4% | $5.04 |
| 6 | $119.70 | 4.8% | $5.78 |
| 7 | $125.48 | 5.3% | $6.67 |
| 8 | $132.15 | 5.8% | $7.73 |
| 9 | $139.88 | 6.4% | $9.00 |
| 10 | $148.87 | 7.1% | $10.53 |
| Total Dividends | $59.41 |
In this instance the shareholder paid $100 for their shares, received $59.41 in dividends, and by reinvesting those dividends would have $159.41 worth of shares paying over $10 per year of dividends at the end of ten years!
The Power of Compounding
We can see that the power of compounding helps to reduce the potential volatility of a company’s stock and can make it easier to grow their shareholder value and wealth. Albert Einstein is reported to have said that exponential growth is the most powerful force in the universe. From an investing point of view, this statement is often very true. This is why we at CH, together with our investment management partners, seek to invest in companies with long term, sustainable and growing dividends.
Best regards,
Brian Trafford, Chief Investment Officer
& Your CH Financial Team