I own a fairly diverse portfolio of common stocks, and one thing puzzles me: the dividend payout (on the ones that even PAY them) is measly indeed-no more than 1-2% at best.
My understanding was that in the 19th century, corporations usually paid out most of their earnings in dividends, unlike today. Of course, there are some companies (usually utilities) that pay our substantial dividends, but this is not the norm these days.
I can understand why many inevstors would prefer the company to increase its stock value via retained earnings (lower capital gains tax rates), but it seems to me that they may have taken this too far. What is the current concensus-is it better to own stocks that pay out healthy dividends, vs, those that pay our nothing (or very low ones), and hope for capital appreciation?
What is your opinion?
I have heard that a few companies are of the opinion that they can spend the money better than you can, so they don’t pay dividends (Microsoft has yet to pay a dividend as far as I know).
I don’t know which I would prefer…I would guess I would lean towards the low-dividend payout because I tend to like the buy-and-hold style of investing. So while I’m holding, if they can use it to increase value, then go for it. Once they stop growing though, I’m going to sell and buy someone else.
I guess you could apply this argument to bonds vs. equities. Do you want a steady payment, or go for the risk and get more in return?
Just my 2 cents.
Several Reasons:
Good for the investor - dividends are taxed when paid, capital gains are taxed only when realized. (Other things being equal, unpaid dividends (excess cash) increase the value of the stock by the amount of the potential dividend)). It’s better to pay taxes later than pay them now most of the time.
Bad management - Management that assumes they can find good business opportunities with that cash, often leads to really bad mergers and the like.
Investor Focus- Growth vs. Income
Frankly dividends of a sort are paid all the time. When a company offers a stock buy back, it gives its shareholders a choice - Cash payout today or capital gains. You can choose if you would like the dividend or not.
Don’t forget that the rate on capital gains for taxes is lower than for dividends, which are taxed as ordinary income. So capital gains are better tax-wise two ways: you’re only taxed when you take them, and you’re taxed at a lower rate.
Being that I have to run a small boodle for someone else for income, and attempt to get some capital gains out of it also, I find myself resenting that dividends are taxed at a higher rate. They should both be taxed at the same rate, IMO. The job is tough enough without having to fight the tax man, too.
Yep, its all about the taxes. Your better off if you don’t get dividends, and so is the firm in the long-run. It may not seem like it, but imagine you hold a stock for 40 years (I know, it doesn’t happen anymore, but lets assume you do), all those dividends that would have been taxed now completely avoid any taxation until you realize your gain on the asset. Therefore, the value of your stock rises tremendously more than it would have had dividends been paided out. Remember what happens when you compound even a small amount like that received from dividends when long time frames are involved. You will be far better off to hold a stock without dividends if you are gonna keep it for the long-run. If you are merely a trader, then don’t worry about it, but if you are investing for the long-run avoid dividends. Why should uncle sam take your gains now, you are better to keep them sheltered from ol uncle sam so it can grow in its entirety.
Are there any comparative studies, which track high-dividend payout companies vs. low divident corporations, over a long period of time? I’d be interested to see exactly which firms provide a better investment.
egkelly -
I’m sure there have been some studies like that, because some PhD candidate had to write about something.
We’re really talking about two kinds of firms. A firm that pays no dividends, theoretically has fewer reinvestment (growth) opportunities than one that does not.
Other things being equal (firms with equal risk profiles) the total return on investment BEFORE taxes, should be the same, provided the dividends can be invested at the same rate of return as the stock on the company that paid them.
With tax effects, at least for recent history, there is no way you can come out ahead (unless the non dividend paying company uses the cash to make really bad investments & acquisitions)because funds left in the firm are reinvested tax free.
But a company that pays no dividends, but carries no debt (interest has tax advantages) and keeps too much cash on the balance sheet (earning minimal returns) isn’t doing you any favors either.
One interesting aspect to all of this is that the value of the corporation is ostensibly limited to the present value of all future dividends that it will pay out. IOW if some law was passed that outlawed all dividends (or other methods of transferring profits to the shareholders) forever, the value of companies stock would (or should) drop to zero immediately. What this seems to mean is that even for companies like Microsoft who have no dividend policies, their value is being paradoxically bolstered by the potential dividends that they (as of now) have no intention of ever giving.
Izzy -
Your initial condition of your hypothetical (owners can’t realize profits) would absolutely drop the share price to zero, because no rational individual would exchange a liquid asset for a completely illiquid, riskier asset without a liquidity & risk premium. You have set the expected return on investment to zero. Dividends are only one expression of this.
If dividends only weren’t allowed, firms would still have value because of 1) the potential for future buyouts from other firms and 2) the potential for stock buybacks (I guess a form of one, only it is buyback by the same firm).
Without the tax implications, Microsoft might pay dividends, they have little debt and generate a lot of cash, and are likely finding fewer and fewer internal investment opportunities for that cash. Since the political climate prevents them from making any acquisitions, they pretty much just sit on that cash.
IzzyR writes:
Who asserts that the value of a share of stock is conditioned by the potential dividend flow from that stock?
I have heard (and often use) that a method of valuing a company is to estimate the future cash flows from it, to see if they will eventually pay for the acquisition price (whether the entire company, or one share of its stock). But cash flows do not equal the potential dividend stream.
The WALTHAM WATCH COMPANY (in business from ca 1858 to around 1957) was a very successful firm, that regularly paid enormous (for its time) dividends on its common stock. During the second world war, it had contracts to supply the US armed forces with clocks, watches, and other navigational instruments, and all through the war, it continued to pay dividends. After the end of WWII, it found itself with an obsolete factory and no money to retool-and promptly went into making losses; leading to its bankruptcy and closing in 1957. So, the shareholders got a lot of money, but lost their capital investment.
I guess the managers of a corporation must choose wisely-sometimes retaining earnings is the only way to stay alive.
Indysloth,
What you are saying boils down to the fact that other corporations can still access the cash flow of the company by buying it outright, without having to receive it in the form of dividends. It would appear that you are right, and I stand corrected. I hadn’t thought of that aspect. Thanks.
One question: Looking at the corporate world on a macro scale, what level of price could be maintained by corporate buyout (or buyback) activity, as compared to the present investment-driven prices?
the huge salaries for the CEOs have to come from somewhere. you don’t think they only rip off the customers and the employees do you? large disorganized groups do not have much power. that includes STOCKHOLDERS. ROFL! and you thought of yourself as a CAPITALIST because you bought some stock. hmmmm.
Dal Timgar
Izzy -
Your question goes right to the heart of the valuation of today’s market. Is it rational or are we sitting on a bubble.
An adherent to efficient markets theory would say that the prices are identical (assuming all tax impacts are the same, they’re probably not in practice).
The assumption implicit in your question is that the markets aren’t totally efficient (investment driven pricing). I think there is some truth to this today. There is so much money pouring into the market because of 401k’s and the like, that fund managers (the less bright ones) in search of yield, and needing a place to put their money are driving the price of equitites higher than the NPV of their future cash flows. If the market is efficient, all this is corrected by smart fund managers selling their holding when the stocks they hold get overpriced, but then they get punished for realizing capital gains for their clients.
So we may be on a bubble.
Traditionally, corporate mergers carry a premium price to entice shareholders of the acquired firm to cough up their shares quickly. Thus the buyout price is often more than the market price (supposedly firms can afford these premiums because of economies from the merger).
Dal_timgar -
That’s another whole topic, the role of managers is public corporations and the fact that they will put their self interest above that of the shareholders. But most of the really huge corporate compensation comes from stock options made good by an increase in the stock price, that way management is rewarded when the stockholders are. Unfortunately management is rarely punished when the stockholders are.
Indysloth,
I’m not sure that these two matters are correlated. Even if a person priced a corporation’s value using only dividends and ignored corporate acquisition possibilities, the stock would still have some value due to the theoretical possibility of dividends. IOW because Microsoft could ultimately decide to issue some dividends, and likely would do this if its stock value sank too far. It’s analogous to a country raising a huge army. Even if that country had no intention of ever actually going to war, the possibility of them doing so would give them some weight. So too, a company can derive its ultimate value from potential dividends and then push off the actual issuance of those dividends so far into the hypothetical future that they may never actually happen. My earlier post envisioned a scenario under which the dividends became impossible even theoretically (i.e. a law banning them). In this instance the situation would be analogous to a country with a huge army that was known to lack the ability to use it for other reasons, which would have no clout at all.
According to the Capital Asset pricing Model (advocated by Merton Miller), it makes no difference what the capital structure of a firm is-equity or debt. But, we do see a difference in the long-term investment performance of bonds vs. stocks-everything I’ve read says that from 1900-the present, common stocks have returned around 9%/yearr, while bonds have yielded around 3-4%.
Debt to equity ratio sure as hell makes a difference in the CAPM,
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The more debt a company has, the less likely the shareholders get paid in the event of a bankruptcy, bad times etc. This makes the company riskier, and it would thus have a higher Beta under capm.
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The interest on debt is tax deductible, this creates an advantage for the remaining shareholders, in that for a given operating profit, the net income is higher if a portion of the capitalization comes from debt. Other things being equal, this firm will have a higher valuation.
These are things that are implicit in the model.
The performance of stocks vs. bonds over time is the risk premium.
I was taught that in evaluating companies for investment, it was wise to place them in a triangle. The three corners of the triangle are Risk (and chance for growth), Security, and Income. The closer a company gets to one of the corners, the further away it gets from the other two.
So:
If you buy an income stock (a REIT is a classic example) you there’s little risk (and little chance for growth) and little security (your equity might go away) but you get the check every quarter.
If you buy a Secure stock, you can count on not losing your stake, but growth and the dividend income will probably be modest . ATT and IBM used to be the classic examples, but nowadays. . .?
If you buy a Risk (Growth) stock, there’s no income and you could lose your shirt, but if things click you’ll be farting through silk. Microsoft and Apple were the classic risk investments back when they were starting. Come to think of it, so were all the dot-coms that bought million-dollar Super Bowl ads and have since shuttered their doors.
The reality of the tax bite already discussed makes income stocks unpopular, unless you’re a retiree living off your investments. That’s probably why most folks aren’t too familiar with them.
FYI, I work for a publicly traded REIT (NYSE UDR). Our stock currently trades between 10-11. We pay better than $1.35 a share annually and have raised the dividend every year for better than 20 years.
I think a lot of the low dividend to price ratio is simply due to the recent large influx of money into the stock market, which has risen the prices of stocks but not their dividends.
Bassguy, I’m looking into your company. That’s a hell of a juicy dividend, and quite a record for increasing it, too. For the someone who’s boodle I’m managing, I own SMT, which has also compiled a good record, but it’s shorter, and the yield is somewhat less.