Study: Why Berkshire Doesn’t Pay Dividends
The Math
Imagine this: You and I are equal owners of a business worth $2m, so each of us own $1m worth. This business earns 12% on existing equity and incremental capital, or $240k in the first year. The market prices our business at 125% of net worth, therefore our market value is $1.25m each.
Under the dividend approach, we agree that our company should payout 1/3 of annual earnings as dividends and 2/3 of it reinvested to grow the business. So out of the $240k earnings, we will pay out $80k and retain $160k in the first year.
In the first year, your dividends (50% ownership) will be $40k. As earnings compounded this 1/3 payout policy is maintained and so your dividends will also compound. Since 1/3 is paid out as dividends, the 12% returns becomes only 8%, so dividends and stock value will compound at this 8%.
After 10 years, the original $2m compounded at 8% would be worth $4.32m. Now, the market is willing to buy our business at 125% of net worth, so our company has a market value of $5.4m. Under the dividend approach, each of us now has $2.7m of market value and we’ll live happily ever after as dividends and market value continues to compound.
However, there’s an alternative approach, what if we retained 100% of earnings and each of us sell 3.2% of our shares annually?
Since shares are worth 125% of net worth in the market, this is equivalent to the 4% dividend payout policy (3.2% * 125% = 4%).
But because we retain all earnings, the initial $2m net worth will compound at the full 12% returns. After 10 years, this $2m will turn into $6.2m. However, our ownership of the business would have declined since we sold 3.2% annually to match the dividend approach.
Your ownership would have declined to 36.12% [=50% * (1-3.2%)¹⁰]. Even so, your net worth in the business will be $2.24m ($6.2m * 36.12%), and your market value will be $2.8m. This number is higher than the $2.7m from the dividend approach above!
So under the selling-shares approach it would give you the same income as paying out dividends but with the added benefit of compounding the business worth at a higher rate.
Of course, all these assumes that our business can earn 12% on existing and incremental capital, and the market is willing to buy the shares at 125% of net worth. In fact, both assumptions are reasonable for Berkshire, although nothing in the future is guaranteed.
Other than the favourable math, there are 2 important arguments for the selling-shares approach:
Shareholders can be flexible to adjust the percentage of shares sold to suit their income needs. For the dividend approach, every shareholder is forced to receive a predetermined amount. Furthermore, for those who wish to reinvest their dividends, they will need to pay 125% of worth and incur frictional costs like commissions.
Tax consequences. Under the dividend approach, all cash received is taxed whereas selling-shares approach only taxes the realized gains.