Investors often talk about profits and free cash flow. I’m no exception. If you look at the archive of articles on this blog, you will find that I have written about both of these subjects numerous times.
So why am I saying that profits and free cash flow are not what really matter and that dividends are what ultimately matters most?
Well, that’s because an asset should be valued based on the cash flow that the asset can produce for the asset holder. In the case of stocks, dividends are the only cash flow you receive as a long-term shareholder.
Business profits may not end up in our pockets
Although profits or free cash flow that a business earns can theoretically be returned to the shareholder, the truth is that, more often than not, they aren’t. Companies may want to retain a portion or all of that cash flow for reinvestment in the business, acquisitions, or buybacks.
Let’s take a look at a simple example.
Company A is a profitable business. It generates $1 in free cash flow in year one. The company does not want to pay a dividend. Instead, it reinvests that $1 to generate 10% more cash flows the subsequent year. It keeps reinvesting its profits each year for 5 years. Only after Year 5 does Company A decide that it will start to return all its free cash flow to shareholders as dividends. Its free cash flow per year stagnates after Year 5. Here is what Company A’s annual free cash flow and dividend per share look like:
Company B, on the other hand, produces $0 in free cash flow in Years 1 to 5. But in Year 6, it starts to generate $1.61 in free cash flow per share and pays all of that out as dividends each year. Like Company A, its growth stagnates after Year 5.
Here is what Company B’s annual free cash flow and dividend per share look like:
Which company is worth more? Neither. They are worth the same. That is because the cash flow received by the shareholders is equal.
Free cash flow and profits do not reflect all costs
If the above example left you slightly confused, maybe you can think of it like this. A company may be generating free cash flow but uses all that cash to grow through acquisitions or conduct share buybacks. Another company may be using its cash from operations to build more capacity to drive growth. The cash spent here are capital expenses which lower free cash flow*.
The first company may appear to be generating a lot of free cash flow but that cash is being spent on buybacks and acquisitions. The second company has no free cash flow but that’s because its investments are deducted before calculating free cash flow. Both these companies end up with no cash that year that can be returned to shareholders even though one is generating free cash flow and the other one is not. The difference lies in where these expenses/investments are recorded.
Capital expenses are deducted in the calculation of free cash flow but cash acquisitions of another company or buybacks usually are not. Correspondingly, a company that is spending heavily on marketing for growth may show up with no operating cash flow at all and consequently no free cash flow. Ultimately, it does not matter how the company invests or whether free cash flow appears on the financial statements. What really matters is how much cash the company can eventually return to shareholders as dividends, now or in the future.
Although it is true that dividends will eventually come from the free cash flow that a company produces, it is not always true that the free cash flow produced in any given year will lead to dividends.
A brief comment on buybacks
This discussion would not be complete without a short discussion on where buybacks fit into the grand scheme of things. Companies often declare that they have “returned” cash to shareholders through buybacks.
However, this cash is only returned to shareholders who actually sell their stock to the company. What do long-term shareholders who do not sell their shares to the company get? They certainly do not receive any cash.
I count buybacks as a form of investment that the company makes. Buybacks increase a company’s free cash flow per share by reducing the outstanding share count. Long-term shareholders benefit as future dividends are now split among fewer shares.
Given this, I do not count buybacks as cash that is “returned” to the long-term shareholder. Instead, I count it as an investment that drives free cash flow per share growth, and eventually, dividend per share growth.
What ultimately matters to long-term shareholders is, hence, dividends. Dividends is the only cash flow that a long-term shareholder receives. And this is what should drive the value of the stock price.
Final word
Don’t get me wrong. I’m not saying that investors should only invest in companies that are paying dividends. Far from it. I personally have a vested interest in many companies that currently don’t pay a dividend.
However, as a long-term shareholder, I’m cognizant of the fact that the value of the stock is dependent on the dividends that the company will pay eventually. Companies that don’t pay a dividend now or even in the near future can still be valuable if they ultimately start paying dividends.
And while cash flows and profits may not always result in dividends, it is the backbone of where dividends come from. As such, it is still important to keep in mind the future cash-generative profile of a company that will ultimately lead to dividend payments.
*Free cash flow is usually calculated as operating cash flow minus any capital expenses such as the purchase of property, plant and equipment or capitalised software costs
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have no vested interest in any companies mentioned. Holdings are subject to change at any time.