With Great Capex, Comes Less Dividend
More you expand as a business (in terms of capex), more your ability to issue dividends comes down.
Now we should not construe this statement literally. I am saying a general theme that I observed.
Before going in, let’s see why dividends were issued in the first place. Because at the end of the day, EPS growth is bound right? But strictly in my opinion, dividends were started because in the 1930s, equity as an asset class was designed to be somewhat like a bond.
So dividends are like coupons.
As per recent data by Capitaline, India Inc has 10-year low payout as a proportion of earnings in 2024. Investments in several new projects are getting momentum. Intuitively it appears that investment in capex would yield more cash flow in the future, hence more reserves and cash for dividends.
But in my opinion, that’s not the case.
Think of Capex as the company's way of saying, "I'm investing in my future, so I can't give you all the money now." Capex is the money a company spends on things like new equipment, buildings, or other long-term assets.
These investments are made to improve the company's operations, increase efficiency, or expand its business. Now, when a company decides to increase its Capex, it means it's spending more money on these long-term investments.
This leads to lower profits because the company is not generating as much revenue from these new assets yet. As a result, the company may have less money available to distribute to shareholders as dividends.
From an accounting perspective, Capex is recorded as an asset on the balance sheet, and the cost is depreciated over the useful life of the asset. Depreciation is a non-cash expense that reduces the value of the asset on the balance sheet over time.
The depreciation expense is recorded on the income statement as an operating expense. Dividends are payments made by a company to its shareholders from its retained earnings.
Dividends are a way for a company to distribute its profits to its shareholders. From an accounting perspective, dividends are recorded as a reduction in retained earnings on the balance sheet and as an expense on the income statement.
When a company increases its Capex, it may reduce the amount of cash available to pay dividends to shareholders. This is because Capex requires a significant amount of cash, which may reduce the company's free cash flow.
Free cash flow is the cash a company generates after accounting for Capex and other expenses. If a company has less free cash flow, it may have less cash available to pay dividends.
For example, let's say Company A has $100 million in free cash flow and decides to increase its Capex by $20 million. This would reduce the company's free cash flow to $80 million.
If the company has a dividend payout ratio of 50%, it would have $40 million available to pay dividends ($80 million x 50%). However, if the company had not increased its Capex, it would have had $50 million available to pay dividends ($100 million x 50%).
That’s a 25% difference!
In summary, from an accounting perspective, Capex reduces a company's free cash flow, which may lead to lower dividends for shareholders.
However, Capex is also an investment in the company's future growth, which may lead to higher profits and dividends in the long run.
Thanks for reading all the way to the end. We might have differences of opinion. But that’s okay. Share your thoughts!
At the end of the day, knowledge first!