I didn’t even come close to answering the question, did I?
Isn’t there a quirk in the US tax system which incentivizes investors to get company profits from increased stock price vs dividends?
If there are good opportunities for investment, then investment may be the best way to increase stock price. However, if possible investments are iffy or would distract too much from the company’s core competence, then a pile of cash may be the best way to increase net assets as a way to increase stock price and therefore potential investor income. E.g.: There may be great potential investments in, say, restaurants but that doesn’t mean that Apple should get involved in restaurants or that it would be a good idea for Apple’s executives to divide their time between restaurants and Apple’s main business.
What this illustrates is that a company sitting on a pile of undistributed cash is just acting as an extremely inefficient bank operating without deposit insurance.
Shareholders are not depositors. If I want someone to keep my cash safe for me, I’ll put it in the bank. If I buy shares, it’s because I’m looking to buy part-ownership of an enterprise which will employ its assets to generate returns for the owners. Those returns can be (a) reinvested in the same enterprise or (b) distributed to owners who can choose to (1) reinvest them in the same enterprise (2) reinvest them in a different enterprise (3) spend them on champagne and icecream (4) etc. etc. The company which doesn’t distribute its returns is effectively requiring all its owners to do (1). As a shareholder, I’d want them to be making a pretty compelling argument to me as to why they should do this.
A $3 dividend on a $50 share price is a 6% rate of return - which is damn good. The market would tend to drive up (not down) the stock value until the dividend rate get in line with other investments.
Though the stock price would be affected by all kinds of other things also.But I’ve never seen anything saying that raising a dividend drives down stock value. It also might be seen as a signal of good future earnings, another reason for the stock price to rise.
If a company hoards cash, what it’s really doing is deleveraging itself. Take an extreme example - suppose a company’s actual business operations are worth $50 a share, and it has amassed a further $50 a share of cash that’s just sitting in the bank. Obviously the share price will be $100. This means that if you want to invest in the company’s business, you can only do so by putting up twice the value of the business. Implicitly, half of what you put up will be invested in the business, and half will generate bank interest. This is the problem that UDS describes above.
But if you bought the stock on margin, i.e. put up $50 and borrow $50 to buy the $100 stock, then you’ve effectively just invested only in the business portion that you want to invest in. To make things tidy, of course, you could borrow the $50 from the same bank where the company deposited it’s cash hoard!
So I’m not sure, in practice, whether a company hoarding cash is really restricting efficient capital allocation significantly.
It is a straightforward fact that if a company distributes assets to shareholders, the stock price immediately drops by the value of those assets. On the “ex-dividend” date (the first day on which owners of a stock do not receive the declared dividend), the stock price will open lower by the amount of the dividend.
If a company’s underlying business is worth $40, and on Monday it has $10 in cash, the stock price will be $50. If it gives out $3 of that cash to the shareholders on Monday evening, on Tuesday morning the stock price will be $47.
Of course, underlying market fluctuations and changes in market perceptions about the valuation of the company’s business are superimposed on this, but there is always a drop in share price equal to the dividend on the ex-dividend date.
Assuming that they foresee no reasonable chance of having other purposes for the cash, no reason at all. But that is a bit tautological.
A company that has good growth prospects will be hesitant to make large dividend payouts as they see possible need for that cash to power that future growth.
Investors are looking for total return. If a company looks poised for impressive net revenue growth then no future expected dividend is needed to attract investors. If less growth is expected then the return needs to come from expected future dividends. Which of course can be cut at anytime (which would drive down the price).
Not sure what Rubio was meaning though. Maybe just that companies will be getting more cash but really don’t have the growth opportunities to utilize it, hence they will instead pay it out as dividends drive up stock price that way (rather than by increasing revenues with growth). And yeah probably some of them would rather not admit that their lack of impressive growth is not due to not enough cash being available.
Doesn’t this analysis assume that stock prices are more static than they really are?
Sure, when the market opens on the ex-dividend day Alice has $4,700 in the value of her stock plus $300 in dividends (assuming, of course that she’s not on a dividend reinvestment plan.) Bob has $5,000 in stock.
Suppose though that both Company A and Company B have each historically paid $1.50 in dividends. By the close of trading a week later, market sentiment may have decided that Company A is going great guns as evidenced by the higher-than-expected dividend, and the price of a share may now have risen back to $50. Alice now has $5300. Market sentiment for Company B though could be that they are experiencing difficulties, causing the stock price to slide to $45. Bob now has $4500 in value. For him to take the trip to Vegas, he’ll need to sell 7 shares (yes, he’ll have a few dollars in cash left over).
Dividends are taxed as ordinary income, while capital gains are taxed at a typically lower rate.
The mystery is thus why any company pays dividends. Saying to your shareholders, “you’re better off taking the money now even with a tax penalty rather than trusting in our company’s future,” is not an inspiring message.
No. Dividends are not taxed as ordinary income. We accept your apology.
The basics: Qualified dividends, as well as capital gains, for individuals in the 25%, 28%, 33% and 35% income-tax brackets will continue to be taxed at 15%. Individuals with more than $400,000 in taxable income—and couples with more than $450,000—will see the rate rise to 20%.Jan 10, 2013
Not really, no. Dividends are not like interest payments. It’s a simple fact that the day after a company distributes assets to shareholders, the company is immediately worth less by that exact amount. And stocks do empirically open lower by the amount of the dividend on the ex-dividend date. (If this were not true, you could make free money by buying the prior day, capturing the dividend, then immediately selling.) Of course, normal market fluctuations are superimposed on this discrete drop, so in any particular case by day’s end the drop may be somewhat more or less, but if you average out over all stocks the drop is equal to the dividend.
A company’s fortunes are not judged (except indirectly) by the amount of dividend they choose to pay out. They are judged by the amount of money their business earns. Any money the company makes still accrues as value to the shareholders, whether the earnings are retained within the company or paid out as dividends. If a company is doing well and making more money, that news will usually be in the market well before any increased dividend attributable to that better performance is paid out. The stock will likely have moved higher to discount improved prospects long before the dividend is paid, and the stock will still drop by the dividend amount on the ex-dividend date.
ETA: Empirically, stocks are not on average more likely to trade higher after the stock price drops by the dividend amount on the ex-dividend date.
You’re trading safety for a higher return. That’s a tradeoff on any investment: the safer the investment, the lower the return. An investor needs to determine what level of risk is acceptable in order to get a better return than you can from a bank.
Besides, many stockholders reinvest their dividends by buying more stock. I’m doing that and when I retire I’ll have more stock and thus more dividend cash if I need it.
Since 2003, ‘qualified dividends’ and capital gains have gotten essentially the same treatment under the US federal tax code. As a practical matter almost all dividends of conventionally structured US domiciled public stock co’s to US investors are ‘qualified’, a lot of dividends from foreign stock mutual fund/ETF’s are also.
The situation you described was true in the US from the 1985 Reagan tax reform to 2003. Further back there was widely varying treatment of both. Table in first link shows US div tax treatment by period, second has a chart of capital gains rate over time. To get a full picture of each period you’d also have to consider what the ordinary income rate was, and for whom. But for example in the 1920’s dividends were tax free and capital gains taxed at 12.5%, in 1939-53 divs again became tax free with cg rate of 25%, so no surprise if dividend payout ratio’s (divs as % of profit) were higher then. But, div payout ratio’s were generally higher than they are now even in periods like the 1954-1985 when divs were taxed at ord income rates up to 70-90% in theory when cgs were never taxed at more than 35%. OTOH as much as people talk about ‘loopholes’ now there were a lot more back then.
This relates to the general question ‘why would a company pay a dividend’ in showing it’s not all about tax, long term historical review make that clear, though tax is one factor.
One big reason companies pay out dividends is simply because management is doing their job under corporate finance theory judging that they cannot deliver a premium return reinvesting that money in the company compared to the investor being able to choose any and all other investments to reinvest if they receive the money as a dividend. That will be clear for example when as likely Apple eventually pays a large special dividend on some of the huge pile of money it will repatriate from overseas under the new tax bill. They will face political pressure to show they are ‘creating jobs’ with it within Apple, but that’s basically political bullshit. There’s no way Apple has projects with a premium return for all that money. And the theory of the tax bill is not that the money would be reinvested in Apple but more likely to be in the US economy generally (debate that theory as you wish, but it isn’t that it would only be reinvested in Apple). The efficient thing to do is return most of it to shareholders so they can decide how to invest it in any and everything else according to their needs and preferences. In less extreme form this is one reason for dividends in general.
Another major one, arguably as important for the ordinary flow of dividends over time is signalling. Paying a dividend shows in concrete terms that the profits recorded are are least in part real, beyond just an auditor saying ‘yeah these financials are legit’. As other posts have mentioned, cutting a dividend has a pessimistic signalling effect about future profits. Increasing them has a positive one, especially given the negative impact (on management credibility) of cutting: a dividend increase shows confidence in a sustained increase in profit.
The discussion about how the stock price drops $1 ex-dividend for a $1 dividend is true but a small and not very relevant part of the discussion of the role of dividends. The value of stocks is the sum of the perpetuity of all future dividends (if you sell the stock to somebody else that’s what they are buying). So it’s almost all about future dividends which are unknown, not about the simple mechanics of how an already announced dividend affects the stock price when the stock goes ex-dividend (ie the date on which investors buying the stock won’t get that particular dividend).
I stand corrected. Thanks!