byHERMAN GASTRELL SEELY
A SCORE and more of active issues on the New York stock and curb exchanges now carry with them quarterly dividend disbursements in stock, rather than in the more time-honored form of checks payable in the coin of the realm. Their companies range in scope from far-flung and influential utility systems to investment trusts, pipe-line units, store chains, and radio supplies.
A number of these corporations became converts to the system of paying dividends in stock shortly after the spectacular collapse of the ‘great bull market’ last November. The change from cash payments was accompanied frequently by an official statement which stressed the wonderfully bright outlook for the future, hinted that competition was temporarily keener, spoke of low inventories in the hands of an eager dealer organization, and then confessed that, despite these encouraging features, it was wise to conserve resources through the new policy.
No such motives can be ascribed, however, to the larger and more stable companies. Particularly in the utility field, their gross incomes have increased year by year in the last seven, cash surpluses have become impressively substantial, and the expansion of services has opened new sources of revenue.
The directors of these soundly managed companies were under no pressure of adverse conditions when they adopted the dividend-in-stock method of rewarding their common shareholders. The change was made deliberately amid an atmosphere of prosperity that would silence even an inveterate pessimist. As such, this policy is a relatively new development in American finance worthy of the closest scrutiny.
Is the stock dividend gold or a gold brick? Is it really a dividend? Is the holder of shares in these sounder companies really receiving a return on his investment? Is it instead merely a dilution of the per share value of the original investment, and an increase in the number of prettily engraved certificates held without a corresponding increase in the assets behind them ?
The first feature that strikes the investigator is that the common stock of these companies is usually of no par value, while the dividends in stock range from 5 to 10 per cent annually. The second is that there is almost invariably a startling spread between the figure at which the quarterly disbursements are charged off on the balance sheet and the actual stock-market value of the securities in question. In extreme cases during the speculative frenzy of 1929 the ratios ran as high as one to twelve.
IN order to analyze better the features of the dividend in stock, let us create a purely hypothetical utility company which in its bookkeeping methods, dividends, and stock values strikes a fair average for those in real life. This company has senior securities, which call for interest payments in cash, and in addition one million shares of no par common stock authorized and outstanding.
Net profits of the company, after all deductions for fixed charges, depreciation, and taxes, are equal to $3 a share on the no par common, which in turn carries a quarterly dividend of 21/2 cent in stock. The book value of this junior security is 22, the company deducts dividends on its balance sheet at a value of $10 a share, and the average market price on a recognized exchange is $60 a share.
We will assume, further, that this utility, like its real counterparts, is well managed and has a good earnings record. Its stockholders have the alternative of receiving their dividends in stock direct or, if they desire, cash. They may sell them to some subsidiary finance unit or investment group closely allied with its controlling interests.
This third party to a dividend-in-stock transaction, where money is desired instead, buys these shares and fractional shares ‘at market’ and makes a very moderate deduction for the service. To all surface intents and purposes, therefore, the stockholder receives practically the full cash market value of the stock dividend disbursement when he requests it.
Unlike a cash dividend, a stock payment converted into cash in this manner is a very complex transaction. Thus the holder of 100 shares of stock in this hypothetical utility receives, instead of 21/2 shares each quarter, a check for $150 the market value of the shares, subject to the moderate deduction of the financing unit. The deduction for this stock on the books of the company, however, will be made at $25.
Wherein lies the financial legerdemain whereby $25 is converted into $150 almost overnight?
In reality the stockholder in question is trading in two assets. The one is the value of the stock as it is carried on the books of the company, The other is the difference between that figure and the market price — in this case, $50 a share.
Just what does this $50 represent? Is it not in reality the capitalization and sale of an equity in an unofficial, intangible, and physical assetless good-will item created by the blind confidence of the investment public?
LOOKING at the transaction in another light, the utility has gone into partnership with its stockholders in selling the dividends in stock to another portion of the investment public, and the certificates in reality represent two companies. If the partnership kept books, the balance sheet for the first fiscal year, after giving effect to a 10 per cent stock dividend, would contain an item something like this: —
1,100,000 shares of stock at $10 share (utility valuation). . . $11,000,000
Public good-will . 55,000,000
Capital stock (1,100,000 shares of stock at market value)
In passing, it might be recalled that any corporation which carries a good-will item out of all proportion to its other assets usually finds itself in financial hot water sooner or later.
In the case of our hypothetical company, difficulties are most likely to be found in an adverse stock market, congressional agitation against that pet bogey, the power trust, a declining commodity and wage trend which would lower its cost of reproduction value and consequently its rate structure, or changes in its management.
Under such conditions, the deduction by the utility company on a $10 a share basis would probably continue, but the market price — and the good-will equity — would decline sharply. If the price dropped to, say, 30, the stockholder who bought at 60 would find his net return in cash dwindling to 5 per cent on his investment. Conversely, of course, any rapid rise in value above 60, through pool manipulation or other causes, would increase the value of the good-will item and the rate of return on his purchase.
THERE is, however, another phase to the dividend-in-stock system — that of possible dilution.
Is, for example, the shareholder who retains his certificates merely accumulating a larger number of sheets of paper with no corresponding gain in assets?
Is the holder who sells his quarterly dividends and receives cash therefor fooling himself into the belief that he has a return on his investment? Is he instead selling a portion of his original share in the assets of the company?
The answer to both questions, so far as it applies to each individual corporation, can be found only through the use of some of the more detailed methods of auditing. Two broad principles, however, may be used to point the way.
If the gross income and net profits of a company increase in direct proportion to the greater number of shares outstanding annually as a result of stock payments, while the book value of each share after the increase remains the same, then the investor is receiving a real dividend.
If the income and net profits lag behind the percentage of increase in the stock outstanding and the book value declines per share as a result of the dividends, then the holder has merely sold a portion of his capital assets in the market under the delusion that it was a return on the investment.
If a company is in the first and fortunate category, there still remains a vicious feature of the dividend-in-stock system to be considered. Cash payments entail no lien on the future financial structure. Dividends in stock pyramid a liability for further dividends that grows to an astounding degree as each year passes.
Money at 10 per cent, compounded quarterly, doubles itself in less than seven and one-half years; at 8 per cent, in approximately eight and three-quarter years; and at 6 per cent, in a little less than twelve years.
CAN these sounder companies which adopted the dividend in stock from choice maintain the terrific pace thus indicated? Can they double their revenues every seven and one-half to twelve years and at the same time maintain a constant book value per share indefinitely?
Or will the steadily mounting pressure of the increased and ever-increasing number of shares outstanding force a return to payments in cash on a correspondingly conservative basis?
Time and the trend of commodity prices, wages, and buying power in this soberer financial era hold the answer.