A few days ago I read an article in Forbes
about an interesting topic: dividend stocks and investors’ preference.
We have heard of big investors making money
over the pats years in not only investing in companies, but also in buying
companies or even in hedging in currencies and other derivatives. The article
in Forbes dated November 28, lists some big investors like George Soros, Warren
Buffet and Prem Watsa. To remind those who may not be aware, Warren Buffet is
the owner of Berkshire Hathaway, and his company has a $3.5 billion investment
in Exxon Mobil. Prem Watsa is the founder of Fairfax Financial, and George
Soros, among other things, was the speculator who took a short position in the
Pound in 1992.
Taking a short position is an option contract
on a currency in this case, the British Pound, where you are speculating that
the currency will fall in value. And it did and George Soros made millions of
dollars. Since the Pound fell in value, the investor buys it for less than he
sold it for (short position).
From the article, Berkshire Hathaway has
invested in Exxon Mobil, which is paying dividends at an annual rate of 6.3%.
Its dividend payout ratio was 31%. Berkshire Hathaway is an American conglomerate
company that oversees and manages a number of subsidiary companies. The company has raised dividends in the last
31 consecutive years. In looking at the Exxon Mobil dividend yield charts, I noticed
that the company has an annual yield of 2.63%. What does this mean? If we
divide dividend per share by the market price per share, we get the yield rate,
or rate of return of the investment. We should ask why are dividends of prime
importance to some investors, and a secondary to others.
First of all, Dividends are a return of equity
to shareholders. Some investors want to receive a regular cash paying dividend
as income, while others are interested to secure capital gains through a rise
in the stock market price. Dividends are not mandatory but once the company
declares them then they are liable to pay them. If a corporation decides not to
distribute dividends from its earnings for expansion (reinvestments), the
expanded operations should produce an increase in Net Income, and as such, each
share of stock would be more valuable.
As we mentioned above, dividends are distribution
of cash or dividends to its owners. They may also decide to distribute instead
of cash, stock dividends. By distributing cash dividends, assets and Owners
Equity decrease. Dividends are not considered an expense, and hence they do not
reduce revenue in the Income Statement when they are distributed. The reason is
that they do not generate revenue, but a distribution of profits to the owners.
Prem Watsa is the founder of Fairfax Financial.
He has invested in BP with a dividend
payout ratio of 10.2%, and a dividend yield of 4.8%. BP cut its dividend in
half after the oil spill in the Gulf of Mexico in 2010. Fairfax is based in
Canada, and is a financial holding company engaged in property, life insurance,
and casualty. Fairfax holds a 10% investment in cell phone BlackBerry.
George Soros has invested in Microsoft with a
3% dividend yield, grew its dividend by 15% in 2013, 25% in 2012 and 23% in
2011.
As we mentioned above, once a company declares
a dividend it is an obligation. So let us look at the accounting perspective of
how it is recorded on the books once dividends are declared. Two entries are required: when a dividend is
declared, the company debits dividends and credits a dividends payable, which
is a liability. An increase in a liability is a credit entry. Recall that from
the basic accounting equation, Assets = Liabilities + Owners Equity. Since liabilities are on the right side of the
equation, an increase is a credit. We debit dividends because they are a
decrease in retained earnings. A decrease in RE is a debit, since RE is on the
right side of the accounting equation, and an increase would be a credit.
So the entry would look like this”
Dr. Dividends (-RE) 100
Cr.
Dividends Payable (+L) 100
Once the dividends are paid, the second entry
on the accounting books is to reverse the liability since it is no longer , and
decrease the cash since the company paid it from its current assets.
Dr. Dividends Payable (-L) 100
Cr. Cash
(-A) 100
The Dividends Payable account is a liability
which comes into existence when the dividend is declared, and discharged when
it is paid. When income has not been
paid out as dividends, it is in retained earnings.
