Corporate Capital Allocation

By Matthew R Smith (B.Com C.Dec)

I am an owner who takes a very big interest in the companies I own a part of.

What I am about to propose is heresy to legions of income-hungry, dividend fans.

Firstly, what I am not saying is that all companies should retain 100% of their earnings. Funnily enough, there are some companies which should not retain 1 cent of their earnings. Those businesses, the ones with low rates of return on equity (ROE) should in fact distribute all earnings to their owners. However, there are companies that should suspend their dividends and retain all their earnings. My reasons follow.

With the removal of the double taxation and implementation of the imputation system, Australian investors have been lapping up these franked dividends since 1987. This silent protest from Australian investors has been so effective that corporate capital allocation now blindingly follows the mantra to the significant cost of the very investors the mantra seeks to serve.

Business owners will be financially significantly better off if, a company stops paying a dividend and can re-invest earnings at a higher rate of return than owners can elsewhere.

Australian directors which are generally part owners are selling themselves and their other business partners short by paying a dividend at present. The following example demonstrates my rational allocation of corporate capital.

Take a company with $10 per share of book value on its balance sheet. Assuming a return on equity of 20% per annum and assume 50% of earnings are paid out as a dividend, as often is the case in Australia. In the first year, earnings per share will be $2 and the dividend will be $1. The retained $1, which is not paid out as a dividend, increases the equity at the end of the year to $11. In year two the company generates a 20% return on equity, this time on $11 per share of book value, producing $2.20 of earnings.

If we now assume the market chooses to never re-rate this stock from a price/earnings multiple or P/E of 10, you will find that in year one the stock price will equal $20 (P/E of 10 x $2 of earnings). In year two, the share price will be $22 (P/E of 10 x $2.20 of earnings).

In year one, you will receive a $1 dividend, and in year two a capital gain of $2 for a total return of 15% ($1 div + $2 gain = $3 / $20 share price = 15%) but had the dividend not been paid, retained earnings would have been $2 and the beginning equity in year two would have been $12.

A 20% ROE, on the newer higher equity of $12 would correspond to earnings per share of $2.40 in year two. If the P/E remains at 10 times earnings the share price would be trading at $24. The owners would have received a 20% return ($0 div + $4 gain = $4 / $20 share price = 20%).

By following the mantra that seeks to serve, the owners have robbed themselves of $2 in capital gains.

For many years, it has been investment hoodoo-guru that as you attain a senior’s card, your portfolio should lean increasingly towards income and clear itself of growth. Unfortunately, the majority of Australian companies irrespective of their returns on equity have been obliged to adhere to the irrationality of flawed financial advice for far too long.

I simply wish to see that business owners don’t miss out as a result and see that dividends are suspended until the Return on Equity equals a company’s weighted average cost of capital.

Kind regards,

Matthew R Smith (B.Com C.Dec)
Private Client Adviser | Authorised Representative: 327 246
RBS Morgans Limited | ABN 49 010 669 726 | AFSL 235410
Unit 3 69 Eyre Street North Ward QLD 4810
PO Box 1663 Townsville QLD 4810
Direct: 07 4771 4577
Email: matthew.smith@rbsmorgans.com
Level 1 Candidate for the CFA Program