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
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
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 doesnt 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 companys enterprise value.
So what should CEOs 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