13 Nov 2009
Serious analysis dictates that dividends are a net drain of company enterprise value.
To paraphrase Einstein, “matter cannot be created or destroyed,” yet this fundamental tenet seems to be ignored when discussing dividends. Despite the popularity of dividend-paying stocks, serious analysis dictates that dividends are a net drain of company enterprise value. Why are we so confused about dividends? There seems to be a misunderstanding of enterprise value and tax-effect because dividend payments by their very nature have a negative expected return.
If a company has just paid $10 million in dividends then its enterprise value has decreased by a corresponding $10 million dollars. No value has been created in the dividend payment, but investors are quick to praise the merits of a dividend-paying stock.
I believe the flawed logic of this problem is ingrained in the dogma of investing. I was sitting beside an economist on a flight to New York City while writing this article and I asked the question, “How much money do you have if a $10 stock pays you $1 dividend?” He said, “$11, the $10 stock plus the $1 in dividend.” In actuality, you still have $10 because the price of stock declines by the value of the dividend to create a net neutral transaction. That is, until you get your tax bill and that $1 dividend turns into $0.85. So in reality, the dividend payment turned your $10 into $9.85. That doesn’t sound like smart financial strategy to me but it is the basis of dividend-paying stocks.
Tax payment on dividends creates immediate value destruction, but is only half the problem. The lost compounding of taxes paid is the real kicker. Every investor has seen retirement charts that show the benefits of IRA and 401(k) contributions that allow for non-taxed income to be invested, compound over a long period of time, and create greater wealth over the long-run than their taxable counterparts. As long-term capital gains and dividend tax rates are equivalent, there is a benefit to holding off on paying taxes. This highlights the long-term problem of holding dividend paying stocks. Charlie Munger of Berkshire Hathaway goes through an example of a 10 percent per annum investment that pays taxes every year versus an investment that pays taxes all at the end. Mr. Munger explains, “you add nearly 2 percent of after-tax return per annum from common stock investments in companies with tiny dividend payout ratios.” Why do you think you have never seen Warren Buffet pay a dividend?
Then why do companies continue to pay dividends? It is simple: investors still demand them. Investors who need current cash flow purchase dividend paying stocks to meet liquidity demands. But they could easily achieve the same effect by selling an amount of stock equivalent to the income needed and have the same cash flow impact as long as dividend and capital gains tax rates are equal. Plus, they would determine the cash flow payment schedule.
There are other reasons that companies continue to issue dividends. In a famous study by Ibbotson and Siegel, it was shown that higher-dividend-yielding stocks outperform low-dividend-yielding stocks. That being said, higher-dividend-paying stocks beat low-dividend-paying stocks by another measure that I believe is more important than the dividend: they simply generate more positive cash flow. I would posit that the cash flow characteristic of the business is the overwhelming factor in their outperformance, not the dividends. In the same study, Ibbotson and Siegel found that 97 percent of returns between 1871 and 2003 came from dividends. Does that mean that if companies would have paid no dividends that the market would have risen only slightly over the past 130+ years? Not at all. If those companies would not have paid dividends, cash balances at those companies would have ballooned and allowed capital gains to make up the difference.
The last reason to support dividend payment is that stocks do not generally go down by the full amount of the dividend over the course of the trading day in which a dividend is paid. Elton and Gruber (1970) and Kalay (1982) both found that stocks generally decline by about 80 percent of the dividend paid. This would suggest that there is some value created by paying a dividend. But as we have highlighted, taxes eat away almost all of that benefit, and an amount equal to the dividend has been subtracted from the company’s enterprise value.
So what should CEO’s do with all that cash if they are no longer paying dividends? In the absence of positive expected return capital investments like new products, projects or acquisitions, they should buy back stock. First, stock buybacks are tax free. No value is created in a buyback but more importantly, no value is destroyed. Second, the stock buyback should have a positive expected return. Clearly, you would not have invested in the company if you did not believe it had a positive expected return, so transitively the repurchase of shares has a positive expected return. “We are unable to think of one rational reason why any company should ever prefer paying dividends rather than repurchasing stock,” according to Laffer and Winegarden (2006). The superiority of share repurchase to dividends is also supported by research from Moser (2005), Campello (2001), and Fisher (1976).
What would change this dynamic? Getting rid of the double taxation of dividends (i.e. dividends are paid from after-tax earnings) would make dividends a fine neutral use of capital. But that certainly does not seem to be the trend and, in fact, the problem gets worse in 2011 when the dividend tax cuts expire and the dividend tax rate goes back to ordinary income tax rates. If this happens, it only exacerbates the value destructive decision to of your dividend paying stocks.
Cameron Hight , CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and CEO of Alpha Theory™ , a risk-adjusted return based Portfolio Management Platform provider.