Dividends are a real mystery to researchers. In 1976, Fischer Black (yes, the same Black as in Black-Scholes!) wrote a seminal paper looking at corporate dividend payments entitled “the Dividend Puzzle”. He concluded:”The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together“. 30 years on, there’s still a lot of intense head-scratching going on in the ivory towers. Why all the confusion? Well, while investors are quick to praise the merits of a dividend-paying stock (especially of late!), the thing that stumps academics is that dividend payments should, by their very nature, have a negative expected return. This is for two main reasons…
Why Dividends Baffle The Brains
Firstly, dividend payment tend to lead to double taxation of income – dividends are paid from after-tax profits and yet investors must pay income tax on dividends. That’s also at a higher rate than capital gains, in most markets. The issue here is not just the immediate value destruction, but also the lost compounding of those taxes over time. Charlie Munger of Berkshire Hathaway gives an example of a 10% 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 per cent of after-tax return per annum from common stock investments in companies with tiny dividend payout ratios.”
Secondly, a dividend distribution is essentially just a partial liquidation of the company. If a company has just paid X million in dividends, then its enterprise value has decreased by a corresponding X million. As Modigliani amp; Miller showed back in the 1960s, regardless of how the firm distributes its income, its value is determined by its basic earning power and its investment decisions. No value has been created by the dividend payment, nada. Indeed, as just mentioned, value is likely to have been destroyed due to the tax effect. As Cameron Hight has written:
“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”.
So why do companies continue to pay dividends?
The short answer is that they do so because investors like them. In fact, they seem to like them so much 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 – even though it would seem that they should (see above). Researcher Elton and Gruber and Kalay both found that stocks generally decline by about 80% of the dividend paid. This would suggest that there is some value created by paying a dividend although taxes eat away almost all of that benefit.
But why do investors ascribe such value to what should be a neutral, if not negative, transaction from an entreprise value perspective? There are a number of competing theories, none of which is really that compelling…
“The Bird in the Hand” Theory
The idea here is that companies that choose to retain earnings are replacing certain dividend flow to shareholder now with an uncertain more distant flow in the future. On this basis, if two companies are exactly the same, the one which pay higher dividends will have their stock valued higher because some investors prefer value now to uncertain capital gains in the future. The problem with this idea is that it falls foul of the issues discussed above. As Aswath Damodaran discusses in this presentation on Returning Cash to the Owners: Dividend Policy, the appropriate comparison is not between present and future value, but between different forms of present value – i.e. between dividends today and price appreciation / capital gains today (because the stock price drops on the ex-dividend day). Of course, in the case of dividends, that value is crystallized today in cash – but if it’s cash you want, sell some shares – and why do you want cash anyway if you’re an equity investor?
The “Selling is Painful” behavioural Theory
This is a behavioural finance based explanation developed by Shefrin and Statman to do with “mental accounting”. This argument comes down to investors wanting to restrict themselves from consuming too much in the present, particularly elderly investors, as they may be retired and rely more heavily on investment income. They therefore purchase dividend paying stocks to meet liquidity demands. Of course, they could easily achieve the same effect by selling an amount of non-dividend paying 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 then. However, that would fall foul of their rules of “self-control”. Since they don’t want to dip into capital, they only allow themselves to consume current income such as dividends. While there might be something to this explanation, it’s hardly the most inspiringly rational of justifications for a dividend fetish.
The “Show Me the Money” Liquidity Hypothesis
Linked to the last one, this view argues that liquidity concerns account for the popularity of dividend-payers. If liquidity is low, high transaction costs incline investors to receive dividends rather than acquire the same amount of homemade dividends by selling their investment. Meanwhile, rational investors prefer liquid stocks and lower the valuation of illiquid stocks. Thus firms with low liquidity pay dividends to compensate for this. Some work by Banerjee found evidence to support this idea, however it doesn’t seem explains the general popularity of dividend stocks, e.g. with large-cap dividend stalwarts like Vodafone or in relatively liquid markets like the UK.
The “We’ve Got So Much Cash” Signalling Theory
This theory argues that dividend increase is a signal of unexpected positive and persistent higher future earnings / free cash flow. Managers typically have more information than the owners of the company and dividends can help convey that missing information to shareholders – they communicate information on how the managers see the “future prospects of the firm”. An increase in payment of dividends may mean that the directors believe that the company have high profitability potential – boards generally hate to suspend dividends and get punished for it , so logically, they will not authorise them lightly – whereas dividend cuts could signal financial problems.
The issue is that this is only one possible interpretation of a dividend increase. It may be a bullish sign of the sentiment of a Board but, equally, a payment of dividends could suggest the companies have nothing better to do with the money. Using a sample of 1025 US firms between 1979 and 1991, Benartzi, Michaely and Thaler studied the relationship between firms’ future earnings and dividend changes but did not find evidence that changes in dividends have the power to predict changes in future earnings. A dividend increase could equally also signal a Board’s willingness to make imprudent financial decisions for the sake of appeasing certain shareholders. On that note, it’s worth highlighting one study that found that 75% of CFOs said that they would be willing to give up long-term gains to meet current quarterly estimates!
The “Safe and Boring” Maturity Theory
This hypothesis suggests maintains that a dividend increase is an indication that the company has entered a mature life-cycle stage of lower profitability but lower risk. According to this view, reaction to news about risk reduction dominates reactions about lower future profits and therefore the stock price response to a dividend increase announcement is viewed as positive. Conversely, the decision to decrease dividends signals the transitioning from a mature to a decline stage with higher systematic risk and even lower profitability. While this is an interesting hypothesis, it has not been widely tested empirically so far, it seems.
The “No More Awful Acquisitions” Free-Cash-Flow Theory
This theory states that a dividend increase reduces the agency problems between shareholders and top management in companies where ownership and control are separated, such as in public companies. Managers have an incentive to overinvest in companies with sizable cash reserves because of empire building etc (eg. Microsoft and Skype perhaps?). On this view, an increase in dividend reduces the free cash available to managers and therefore limits the chances of them running off and making an awful acquisition.
Frankly, though, if an investor is concerned with a management team’s ineptitude towards managing balance sheet cash, then there are other fundamental issues with regards to their ability to make sound investment decisions. If so, perhaps it isn’t a company you would want to be owning in the first place?
So there you have it. Investors just LOVE dividends but… no-one really knows why, even after 30 years of studies! Perhaps this is because there’s not just one explanation, but a complex mix of factors. Still, one can’t help but feeling that none of the explanations above have really nailed it. So are we all just mad or is there some vein of rationality that’s escaped the boffins. Views welcome.
- The Dividend Puzzle
- The Problem with Dividends
- Stock Price Sensitivity to Dividend Changes
- The Dividend Puzzle: Retention vs. Distribution
- Is the Dividend Puzzle Solved?
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