If you invest for dividends, you would pick stocks that are profitable and invest in them for recurring yields. Over time, as profits increase, so does your dividend income.

But have a read of Warren Buffett’s writing on dividends in his annual letter from 2012, and your perception of dividends just might evolve marginally.

Buffett’s letter discusses when dividends are “appropriate” and when they are not. Here are some lessons on investment you could learn from the master.

Determining the sensibility of dividends

Imagine a business called Z Bhd, which has a track record of earning profits, in cash, consistently. In its latest year, Z Bhd generated RM50 million in profit. So, how much dividends should it pay out?

According to Buffett, the answer lies in Z Bhd’s ability to reinvest its cash to grow future profits. Can it turn RM50 million into an amount greater than RM50 million?

If yes, Z Bhd should retain the RM50 million for investment. Otherwise, it should return the RM50 million to investors in the form of dividends.

So, what options does Z Bhd have in terms of reinvesting its profit for even greater profit? In general, there are three routes it could take:

1. Capital expenditures (capex)

Some questions Z Bhd should be asking include:

• Can it reinvest its RM50 million into expanding its current businesses?
• Can it strengthen its economic moat by becoming more efficient, broadening geographically, lifting its market share, increasing its product and service lines, and so on?
• Assuming it is a market leader, can it widen the gap between itself and its closest peers?

If the answers are “yes”, then Z Bhd should first prioritise its allocation of the RM50 million into capex.

2. Business acquisitions

Let’s say Z Bhd only requires RM10 million for capex. That leaves it with RM40 million to utilise. It could then consider acquiring businesses, which can either be strategic to its current products and services or entirely unrelated.

Z Bhd could acquire its competitor to enhance market leadership in its industry. It could acquire its suppliers to dictate the cost, time and quality of its supplies, which would lead to greater efficiency.

Z Bhd could also acquire its distributors and retailers to dictate its sales channel, which would lead to better margins.

Unrelated acquisitions are common among diversified conglomerates, which act like a fund or portfolio manager. If Z Bhd is a conglomerate with wide business interests, its managers could either channel its profits from one business to another that requires capex, or to invest in a new business to further diversify its portfolio.

3. Share buybacks

Let’s assume Z Bhd opts to invest another RM10 million into acquisitions. This leaves it with RM30 million to utilise.

The next option it could consider is buying back its own shares in the stock market. But this requires Z Bhd’s managers to first know the intrinsic value of its own shares.

Let’s say the company has an intrinsic value of RM10 a share, but trades at RM8 a share. In this case, Z Bhd could buy back its stock at RM8 a share – a 20% discount off its intrinsic value.

As Buffett quotes, it’s hard to go wrong when you’re buying dollars for 80 cents or less!

But if Z Bhd were to trade at RM12 a share, it would then make no sense for it to buy back its own shares at a premium.

Finally, the dividends…

According to Buffett, Z Bhd should first consider the three options above before paying out dividends. If the company has excess cash and has no idea how to maximise its value, only then should it pay out dividends.

So, the answer as to whether dividends “make sense” or not can be answered as follows:

• If Z Bhd can turn RM50 million into >RM50 million, dividends don’t make sense.
• If Z Bhd cannot turn RM50 million into >RM50 million, dividends make sense.

For investors, it is ultimately a stock’s capacity to reinvest that determines its ability to further grow and compound wealth in the long term.

This article first appeared in KCLau.com.

Ian Tai is a financial content writer, dividend investor, and author of many articles on finance featured on KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’ and ‘Small Cap Asia’ in Singapore.