Last week Starbucks announced a big change in their financial policies. For the first time, the Seattle based company will begin paying dividends to stockholders. The company is touting this as proof that their turnaround plan is working. I’m skeptical. The management team may be turning the company around, but the fact that they are starting to pay dividends indicates to me that the company may have its best days as an investment behind it.
Think of it this way: Imagine that you have a business that is profitable. You have a decision to make. What are you going to do with the profits? You basically have two choices. One choice is to take the money out of the business, and give the profits back to the owners of the company. The alternative is to take the profits, and reinvest them back in the business. With the alternative of reinvestment, your hope and plan is to grow the business, and thereby make future profits even larger than they are now.
As an investor, a growing company provides a better return than an equally profitable company that is not growing. Picture two businesses. One business is going to earn a dollar a share this year, next year, and the year after that. The other business is going to earn a dollar a share this year, $1.50 next year, and $2.00 per share two years out. Which business would be worth more to you? You pay more today to capture the larger future cash flow.
The anticipation of larger future profits results in a higher multiplier between the current earnings and the price of a share of stock. Growing companies command a higher price/earnings ratio. As the manager of a business, you want to grow your earnings, because that makes the business more valuable, providing the highest return to the owners, the stockholders. Besides, most senior corporate execs have a large chunk of their compensation in stock options. Increasing the value of the shares benefits them personally.
But there is a risk with this model. What if you reinvest your profits in the business, but you fail to grow your earnings? Well, the technical term for this process is “pissing your money away.” The market hammers you for that.
If you think you have lots of opportunities to grow your business, you should reinvest your profits back into the business. If you don’t think you have as many chances to grow your earnings, then it becomes time to start pulling money out and giving it back to the owners.
The fact that Starbucks is going to start paying a dividend, returning profits to the stockholders, indicates to me that the management of the company thinks the days of their fastest growth are behind them. Which means as an investment, it is time to look for the next company that has the potential to grow quickly.
Starbucks. I love the coffee, but I’m not so wild about the investment.
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