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Shareholders, managements and dividends

Graham on what owners should expect of managers and dividends, and Zweig on proxy statements, buybacks and executive pay.

FinanceGraham ch. 19About 5 min: 3 reading, 2 practiceUpdated

General education, not financial advice.

After this lesson you can
  • State Graham's test for a company's dividend policy
  • Check whether retained earnings have raised earnings per share
  • Explain Zweig's concerns about buybacks and option pay
The Intelligent Investor: Benjamin Graham's ideas: lesson 20 of 24
  1. Graham ch. 1
  2. Investment versus speculation 4 min
  3. Graham ch. 2
  4. Inflation and the investor 4 min
  5. Graham ch. 3
  6. A century of market history 5 min
  7. Graham ch. 4
  8. The defensive investor's portfolio 4 min
  9. Graham ch. 5
  10. Defensive investors and stocks 4 min
  11. Graham ch. 6
  12. What the enterprising investor avoids 4 min
  13. Graham ch. 7
  14. What the enterprising investor does 5 min
  15. Graham ch. 8
  16. Mr. Market 5 min
  17. Living with fluctuations 5 min
  18. Graham ch. 9
  19. Investing in funds 5 min
  20. Graham ch. 10
  21. The investor and his advisers 4 min
  22. Graham ch. 11
  23. Security analysis for the lay investor 4 min
  24. Graham ch. 12
  25. Per-share earnings and their traps 4 min
  26. Graham ch. 13
  27. Comparing four companies 4 min
  28. Graham ch. 14
  29. The defensive investor's screen 4 min
  30. Graham ch. 15
  31. The enterprising investor's screen 7 min
  32. Graham ch. 16
  33. Convertibles and warrants 6 min
  34. Graham ch. 17
  35. Four extreme case histories 7 min
  36. Graham ch. 18
  37. Eight pairs of companies 7 min
  38. Graham ch. 19
  39. Shareholders, managements and dividends 5 min
  40. Graham ch. 20
  41. Margin of safety (1): the idea 5 min
  42. Margin of safety (2): in practice 7 min
  43. Graham appendix 1
  44. The superinvestors of Graham-and-Doddsville 6 min
  45. Graham postscript
  46. Graham today 7 min

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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 19, "Shareholders and Managements: Dividend Policy"

What it is

Shareholders as owners. Graham argued from 1934 onwards that shareholders should act like owners: be generous to managers who do well, and demand explanations when results are poor. He says questions about management are justified when results are:

  1. unsatisfactory in themselves,
  2. worse than those of similar companies, and
  3. the cause of a poor share price over a long period.

By his last revision he admits that shareholders had achieved almost nothing this way. Poor managements were changed mainly by takeovers: a low share price attracts buyers who can run the business better.

Dividend policy. Graham's test: shareholders should expect either

  • a normal payout, around two-thirds of earnings, or
  • a clear demonstration that the earnings kept in the business have produced a satisfactory rise in earnings per share.

A recognised growth company can usually show this. A mediocre company that keeps its earnings "to expand", under the same management, should give a full explanation and a convincing defence first.

Quick check

Tap an answer to check it.

  1. A company earns 4 per share and pays 1 in dividends. What is its payout ratio?

    Show answer

    25%. 1 ÷ 4 = 0.25. Graham's "normal" payout was about two-thirds.

Why it matters

Earnings kept in the company belong to the shareholders as much as dividends do. If they are reinvested well, earnings per share should grow; if not, the owners would have been better off with the cash.

Zweig's commentary (2003). Graham cut this chapter heavily in later editions; Zweig infers that he had given up on shareholders taking an interest. Zweig brings back his earlier arguments and adds his own:

  • Read the proxy statement. It shows managers' pay, their share ownership and any deals between insiders and the company. Enron's 1999 proxy disclosed that its finance chief ran partnerships buying assets from Enron, a plain conflict of interest.
  • Dividends discipline managers. He cites research finding that companies paying higher dividends went on to faster earnings growth, and that dividend increases were followed by higher profitability. In his view, paying cash out leaves managers less to waste or hoard.
  • Buybacks. Buying back shares at low prices can be a good use of spare cash. But Zweig shows companies buying back at high prices mainly to offset shares issued to executives through stock options, issuing low and buying high.
  • Executive pay. He suggests voting against option plans that hand managers more than 3% of the shares, and against plans not tied to lasting, superior results (for example, beating the industry average over at least five years).

Worked example

A made-up company over five years:

  • Earnings per share start at 3.00. It pays 1.00 a year and keeps 2.00 a share.
  • Over five years it keeps 5 × 2.00 = 10.00 a share.
  • Earnings per share are now 3.20: a rise of 0.20.

The 10.00 kept back has added 0.20 a year of earnings, a return of 0.20 ÷ 10.00 = 2%. A savings account might have done better. By Graham's test, this company has not shown that keeping the money was worthwhile, and its owners have a right to ask why it did not pay more out.

Common mistake

Assuming a buyback always benefits shareholders. A buyback reduces the number of shares, so earnings per share rise. But if the company pays more than the shares are worth, or is mainly buying back shares it just issued to executives cheaply, the remaining owners lose.

Key terms

payout ratio
dividends ÷ earnings
retained earnings
earnings kept in the business instead of paid out
buyback
a company buying its own shares, reducing the number outstanding
proxy statement
the document sent to shareholders before the annual meeting, covering votes, pay and insider dealings
stock option
a right given to employees to buy shares at a set price

Practise the key terms

Tap a card to turn it over. 5 cards.

FrontBack
payout ratiodividends ÷ earnings
retained earningsearnings kept in the business instead of paid out
buybacka company buying its own shares, reducing the number outstanding
proxy statementthe document sent to shareholders before the annual meeting, covering votes, pay and insider dealings
stock optiona right given to employees to buy shares at a set price

Practice

Work it through

A company earns 100 million and has 50 million shares. It spends cash buying back 5 million shares.

Quick quiz

Tap an answer to check it.

  1. What did Graham say shareholders should expect on dividends?

    Show answer

    About two-thirds of earnings paid out, or proof that retained earnings raised per-share earnings satisfactorily. The test applies to companies not held back by weak finances; growth companies can usually pass the second part.

  2. By the time of his last revision, how did Graham say poor managements were usually changed?

    Show answer

    By takeovers, when a low share price attracted buyers. Outsiders could bid for control when the price was low.

  3. Why did Zweig call some buybacks "sell low, buy high"?

    Show answer

    Companies issued shares cheaply to executives through options, then bought shares back at much higher market prices. Oracle, in his example, issued shares to insiders at about 3.53 and bought back at about 18.26.

In short

  • Graham: shareholders should act as owners; in practice, takeovers did more to change poor managements.
  • Dividend test: about two-thirds paid out, or proof that retained earnings raised earnings per share.
  • Zweig: read the proxy statement; dividends discipline managers; buybacks are good only at sensible prices; vote against option plans over 3% of shares.

Mastery check

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Check yourself

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  1. What payout did Graham describe as normal?

    Show answer

    About two-thirds of earnings.

  2. A company retained 8 per share over several years, and its yearly earnings per share rose by 0.40. What return did the retained earnings make?

    Show answer

    5% (0.40 ÷ 8: the extra yearly earnings on the money kept).

  3. Which document does Zweig say every owner should read?

    Show answer

    The proxy statement.

Further reading