DIVIDENDS AND ITS MARGIN-OF SAFETY

Dividend policy is a major capital allocation issue that is less interpreted by investors. Buffett’s essays clarify this subject, emphasizing that “capital allocation is crucial to business and investment management.” In early 1998, Berkshire’s common stock was priced in the market at over $50,000 per share and the company’s book value, earnings, and intrinsic value have steadily increased well in excess of average annual rates. Yet the company has never affected a stock split, and has not paid a cash dividend.

Apart from minimization of transaction costs, Berkshire’s dividend policy also reflects Buffett’s conviction that a company’s earnings payout versus retention decision should be based on a single test: each dollar of earnings should be retained if retention will increase market value by at least a like amount; otherwise it should be paid out. Earnings retention is justified only when “capital retained produces incremental earnings equal to, or above, those generally available to investors.”

Margin of Safety in Dividends (Source: Dividend Growth Investor)

One should typically look for a margin of safety in dividends in corporations to be 50%-60% or below. This means that the dividend payout ratio should not be over 60% because when a company pays out almost all of its earnings as dividends; it leaves little for investing and growing the business.

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