Thursday, August 21, 2008

The Good and the Bad of Scrip Dividends

I am attempting to articulate my random thoughts on whether it is better to receive cash dividends or scrip issue in terms of stocks.

A scrip dividend is a scrip issue of shares made in lieu of a cash dividend. Shareholders are able to choose between the cash dividend or shares.

Before writing about the good and the bad of scrip dividends, there are a few points or assumptions that must be made clear. Firstly, the stock that one has bought is indeed a business worth investing in. (Otherwise why would one be owning the stock?) Secondly, it is assumed that one is already open to the idea of company paying out dividends . Lastly, the good or bad of scrip dividends should come from an investor-centric viewpoint and not from a company-centric viewpoint. (Of course at the end of the day, it is the company which benefits as they get to pay less in cash dividends and reinvest it in their business). Good or bad can only be defined in relation to another shareholder who makes the direct opposite decision compared to yours.

Based on the first assumption mentioned above, one has bought into the stock of a company because you must have believed it is a good company.

Based on the second assumption, one is not adverse to the idea of receiving dividends from the company. If not, one would have invested in a stock that does not pay out dividends.

With this I go on to an illustration :

Ah Beng, John and Miss Long invests in a business. They each have one third share in the business so profits are split equally 3 ways over the years. One day, Miss Long comes up with a plan that instead of paying out cash to the 3 of them, the business should reinvest that money for expansion, advertising,etc. She willingly volunteers to receive a greater share in the ownership of the company while forgoing her share in the profits.

Ah Beng was disturbed as the status quo would be shaken. He always had a one third stake in the company. To him, if the company grew to become worth 3 million in the future, he would be an instant millionaire. So he stuck with Miss Long and decided that he would not receive any profits too but receive more shares.

John was skeptical as he still wanted his yearly cash dividends payout but was worried about the status quo changing and he having lesser and lesser cash dividends he was entitled to each year while the rest would have a larger and larger ownership in the company.

So is the scrip dividends good for Ah Beng, John and Miss Long?

It is good for Ah Beng and Miss Long as they both see potential in the business and believe that the money can be better reinvested in the business. But it is only truly good if the capital gains they get over the years is better than the capital gains + cash dividends that John gets over the years. Why should one guy be getting $$ from the business while the other shareholders are not and at the end of the day, the guy who was receiving his yearly cash dividends is still better off from the whole deal?

What's more, the yearly cash dividends that he was receiving was made possible in part because the rest of the shareholders forfeited their yearly cash dividend payouts. to reinvest in the business.

So scrip dividends are neither good nor bad in itself. It is a way to allow shareholders the option to receive cash or greater ownership in the company. But those who forfeit their yearly cash dividends should not at the end of the day be worse off than those who received their yearly cash dividends.

So imagine if Berkshire Hathaway announces that it will be giving the option of scrip dividends. And imagine again that the dividend payout this year is the value of 1 stock or $100,000 in cash. If 2 guys both own 1 stock each of Berkshire Hathaway. One opts for the cash, the other opts for the stock.

Next year, if Berkshire Hathaway share price rises to $200,000 and both guys sell the stocks, one guy would have gotten $300,000 while the other obtained $400,000. The guy who opted for the scrip dividends "wins" and rightly so.

What if Berkshire Hathaway share price remains the same? One guy gets $400,000 while the other guy who forfeited his dividends also gets $400,000. This is the guy who reinvests his money into the business but receives no greater gain than the guy who did not reinvest his money into the business.

What if Berkshire Hathaway share price drops to $20,000. The guy again who opted for the cash dividends "wins".

In conclusion, to me personally, scrip dividends is good if one believes that the following will be true(this is an oversimpliciation):

Future share price x no. of scrip dividend shares > total cash dividends forfeited

The only unknown variable is the future share price. And that is a decision each individual investor would have to "forecast" to make the decision of whether to receive scrip dividends or to receive cash dividends. In general, if i believe that the stock price would go up, opt for the scrip dividends.

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