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Deciding whether to reinvest your dividend?

Have you ever wondered whether you should reinvest your dividends? Or were you ever at a loss between choosing to receive cash or new shares when a scrip dividend is offered?

The investor should look at the relationship between profits retained and market capitalisation

According to a study carried out by Prof. Dimson et al of the London Business School, if you had invested $1 in US Stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. However, if you had reinvested all your dividends, your stock portfolio would have been worth $16,979.

In light of this study, reinvesting one’s dividend seems to be the best approach if the investor is holding his investments as a savings or retirement plan. However, reinvesting dividends blindly is as dangerous as buying shares without carrying out a diligent analysis.

Benjamin Graham, the first proponent of value investing and a very influential person in Warren Buffet’s life, sets one standard rule on profits retained by a company. For every dollar increase in profits retained, one dollar of market capitalisation must be created for owners. To understand this better, one can (by way of analogy) think of a depositor who does not withdraw interest earned on a term deposit. The value of the deposit increases by that interest saved and likewise the market value of a company that retains its profits should at least increase by the value of the profit retained.

To Warren Buffett, the ability to use retained earnings wisely is a sign of good company management. If management cannot do any better with earnings, then the wise decision would be to pay them out. We have analysed the local listed market from this perspective and the results are summarised in the table.

Clearly, one euro of equity accumulated did not always increase the market cap by one euro or more. Out of 13 companies, only seven registered a larger increase in market cap when compared to the amount of equity accumulated. Maybe this is why the market has a stubborn habit of valuing distributed earnings more generously than profits retained.

We make a number of key observations on the basis of this small study. Firstly, an investor must look at fundamental indicators. It does not make financial sense to reinvest profits in a company that is earning a low return on equity and one must be cautious when stocks are selling at high P/E ratios.

Secondly, the investor should look at the relationship between profits retained and market capitalisation. Graham and Buffet advise to avoid stocks whose profits retained do not give rise to at least a corresponding increase in market cap.

Thirdly, dividend is key. In principle, we agree that the value of a company should reflect its ability to generate earnings and not how these earnings are distributed. However, if earnings retained are not always successfully translated into market cap, the dividend yield (and any expected growth in dividend) may be more important than you otherwise would have thought.

The views and opinions expressed in this article are solely of the authors and do not reflect the views of the users of the website, its affiliates or of any financial institution. This article is solely for information purposes and is not to be construed as a recommendation, a solicitation or an offer to buy or sell any securities or related financial instruments.

Company name   Increase in Equity* Change in market cap**
6pm Holdings plc £ 2,100,016 871,100
Bank of Valletta plc 128,084,000 346,800,000
FIMBank plc $ 9,374,771 (30,940,310)
HSBC Bank Malta plc 105,940,000 175,104,000
Lombard Bank Malta plc 16,702,000 (18,034,745)
Malta International Airport plc 5,989,638 104,181,000
MaltaPost plc 5,733,000 13,142,344
Medserv plc 899,752 4,400,000
Middlesea Insurance plc 56,449,000 16,640,000
MIDI plc 902,269 (36,407,165)
RS2 Software Plc 4,761,922 7,000,000
Santumas Shareholdings plc 309,547 (2,081,435)
Simonds Farsons Cisk plc 6,784,000 31,500,000

Ideally this study would have covered a long time horizon. However, the peaks reached in 2007 and the market bottom in 2009 skewed our results. To mitigate this ‘noise’, we carried out analysis by comparing the shareholders’ equity of listed companies between the end of 2008 and that published in the most recent financial statements. We then compared this movement with the change in market capitalisation between April 2009 (which was the bottom of the market) and today.

*Increase in equity between 2008 and the most recent financial statements. If the company was listed after this date, the period covered starts from the listing date. Shareholders’ equity excludes non-controlling interest.

**Change in market cap between April 2009 and the date of writing of this article (January 25).

This table only shows companies whose equity increased over the period under review since the goal of this study is to investigate whether equity increases gave rise to at least a corresponding increase in market value.

Chris Grech and Calvin Bartolo are co-founders of financial website http://blackdigits.com.mt .

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