October 29, 2022

Security Analysis - Chapters 29 and 30

Security Analysis by Benjamin Graham and David Dodd was first published in 1934. It is a fundamental book for serious students of value investing.

Given dividend has been a factor in the valuation of equities, Mr. Graham and Mr. Dodd discuss the appropriate dividend policy and analyze the past and present policies for both cash and stock dividends.

In general, companies with similar earning power have different valuations given their dividend rate. Higher the rate higher the valuation. While this fact is seen in various examples, the appropriate retention of earnings should be driven by improving the balance sheet and/or increasing earning power by reinvestment of the excess earnings. The rest should be given back to stockholders. 

The authors point out frequent cases of retained capital misuse. That is driven by management's ambitions of empire-building, increasing cash reserves to hide financial problems, or pleasing large shareholders. These factors led to a distrust of retaining large sums of earnings. 

The distributions made in stock dividend form are usually done to capitalize against the surplus or unpaid current earnings. While the benefit of split-ups and one-time stock dividends is to adjust the stock price to a reasonable level, this practice could be abused by insiders and is subject to speculation. 

Regular stock dividends have various advantages around convenience and increased management accountability. Nonetheless, it has been subject to various manipulations both consciously and unconsciously by companies. One of the most common issues is the difference in book value and market value of the stock dividends.

The writers conclude that appropriate dividend policy and reinvestment amount should be based on shareholders' rational decisions. There might be cases where large retention is justified. Nonetheless, in general, large retention should be scrutinized as it could be subject to management abuse.

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