BULLS & BEARS: Some companies lose way when they reinvest profits

In a previous column, I described “free cash flow” as the earnings remaining after a company makes the necessary expenditures to keep the business viable in its industry.

Executives at companies that generate unrestricted earnings, or free cash flow, have critical decisions to make on how to allocate those funds. One choice is to pay out dividends to shareholders.

Decades ago, dividends composed a significant portion of the overall return achieved by investing in common stocks. Following the post-WWII economic boom, the emphasis on paying dividends decreased.

Corporations migrated toward reinvesting earnings to fund growth, and capital gains became of greater importance to stock investors. Tax policy also was a factor in this preference of capital gains over dividends, since dividends were taxed at higher rates.

However, 2003 legislation lowered the maximum tax rate on dividends to 15 percent, essentially taxing them on par with long-term capital gains. This lower tax rate, combined with investor dissatisfaction over corporate malfeasance, has reignited a clamor for companies to pay out more of their earnings in dividends.

The decision of management regarding dividend policy should, in theory, be straightforward. Companies should retain their unrestricted earnings only if they can reinvest them at a rate of return higher than the investor could reasonably expect to achieve on his or her own.

If a company can realize higher returns, the business value created over time will provide a greater benefit to shareholders than a policy of distributing free cash flow in dividends. A shareholder needing cash could simply sell the required amount of stock to meet his or her needs.

On the other hand, shareholders should demand higher cash payouts from companies with a poor record of reinvesting retained earnings.

A five-year period should provide an adequate time frame to determine if shareholder value has been created from retained earnings.

When companies announce restructuring charges or write-offs, this is usually a sign to investors that earnings retained in the past were squandered on projects that subtracted from shareholder value. In these cases, it would have been better for shareholders if those earnings had been distributed as dividends.

Even businesses with excellent economics from time to time fall victim to poor decisions regarding allocation of their tremendous free cash flow. Examples of this would include Coca-Cola Co.’s purchase of Columbia Pictures, or Time Warner’s acquisition of AOL.

The desire by management to expand the corporate empire led these titans into acquisitions that suppressed shareholder value. The stockholders would have been much better off if the cash had been paid to them in dividends vs. reinvested in subpar businesses.

Typically, mature businesses will pay out a higher percentage of earnings to shareholders as dividends, while companies in a growth phase will retain the majority of earnings to fund expansion.

Executives’ decisions on dividend policy and their track record on earnings retention deserve attention from investors because they can have a significant effect on returns.