Cover Image for Understanding Dividends and Growth Rates: Key Factors for Smart Investing
Chapter 7

Understanding Dividends and Growth Rates: Key Factors for Smart Investing

In this exploration, we'll uncover the significance of dividends, how to evaluate them, and a neat trick to calculate growth rates without a calculator. Whether you're a seasoned investor or just starting out, understanding these concepts is essential for making informed investment decisions.

The Dividend Dilemma: CEO's Decision

In the realm of investments, dividends are a fascinating dimension. When a business has surplus cash, the CEO must decide whether to distribute it to shareholders or invest it back into the business. This decision hinges on the CEO's confidence in achieving a high Return on Invested Capital (ROIC). If growth prospects are promising, it might make sense to keep the money and reinvest for future expansion. However, if the CEO can't efficiently allocate all the surplus cash, giving back a portion as dividends is prudent.

Dividends: Not Good or Bad, Just a Choice

It's important to note that paying dividends doesn't inherently indicate slow or fast growth. Businesses opt for dividends based on their unique circumstances. Some companies like Procter and Gamble and Microsoft, despite having strong moats, pay dividends as they believe they can't grow any faster. Others, like Starbucks, choose to reinvest every penny into growth and thus don't pay dividends. As Rule #1 investors, we don't base our decisions on dividend payment; instead, we focus on evaluating a business holistically.

Evaluating Dividends: The Good and the Bad

A well-thought-out dividend is one where the CEO acknowledges that retaining excess cash could result in diminishing ROIC. By distributing this cash to shareholders, the CEO allows for more efficient capital allocation. On the other hand, a bad dividend is one where the CEO distributes money that could have been used to fuel business growth. General Motors serves as an example, as its financial position might have been stronger had it reinvested instead of paying dividends it couldn't afford.

Dividends and Taxes: A Complex Landscape

Dividend payment is a complex matter intertwined with taxation policies. Before distributing dividends, businesses pay taxes on earnings, leading to double taxation on dividends received by shareholders. This double taxation can substantially reduce the actual amount shareholders receive. This phenomenon can influence a company's decision to pay dividends and can even affect the competitiveness of American businesses on the global stage.

Growth Rate Calculation: Simplified with the Rule of 72

Now, let's unravel the trick to calculate growth rates without a calculator—the Rule of 72. This nifty technique involves estimating how many years it takes for an amount to double at a certain growth rate. For instance, if a value doubled twice in five years, it takes about 2.4 years for it to double once. By dividing 72 by the doubling time, you get the growth rate. This simple yet powerful method provides a quick estimate of growth rates without complex calculations.

Putting It All Together: Making Informed Decisions

In the realm of investing, dividends, and growth rates are essential considerations. They provide insights into a company's financial strategy and prospects for future growth. As a Rule #1 investor, you're equipped to assess whether a dividend is prudent and to calculate growth rates using the Rule of 72. Armed with this knowledge, you can confidently navigate the investment landscape, making informed choices that align with your financial goals. Remember, successful investing is about understanding the nuances and using them to your advantage.