Warren Buffett - What dividends tell you about prospects of a company

Key takeaways at the end

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A profitable company can allocate its earnings in various ways (which are not mutually exclusive). A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors.

2012 Shareholder Letter

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Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend pay-out so that owners could direct capital toward more attractive areas.

1981 Shareholder Letter

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[...] We believe there is only one valid reason for retention. Unrestricted 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 produces incremental earnings equal to, or above, those generally available to investors. [...]

Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, [...] but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future.

However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.

1984 Shareholder Letter

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The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

1992 Shareholder Letter

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Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value. Almost by definition, a really good business generates far more money [...] than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That's like asking your interior decorator whether you need a $50,000 rug.

1994 Shareholder Letter

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I will quote John Maynard Keynes: “[...] Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.” 

It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was published. After all, it was no secret that mind-boggling wealth had earlier been amassed by such titans as Carnegie, Rockefeller and Ford, all of whom had retained a huge portion of their business earnings to fund growth and produce ever-greater profits. [...]

2019 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• Understanding capital allocation is important: As an investor, you should understand how companies in your portfolio are allocating capital and what they are doing with generated earnings. Over time, capital allocation decisions will have a big impact, positive or negative, on value due to compounding effect.

• Internal projects first: Companies should typically first look to re-deploy capital on internal projects (product innovation, widening of the competitive moat). These projects should earn a return on capital that is higher than the alternative return you can get in the market. If this is met, the best businesses will deploy large amounts over long periods and therefore benefit most from the compounding effect. A company should return capital (via dividend or share repurchase) to investors if the above criteria are not met.

• The pay-out paradox: Almost by definition, good businesses will not need as much capital to grow their business or to extend their moat. In that case it is better to return (part of) capital to shareholders rather than to engage in M&A or other empire-building projects driven by management egos.