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A dividend is a payment from a corporation to its shareholders.
Investors
will not give money to firms unless the firm plans to give money back
to
the investors. In some way there must be an expectation that
the
financial loop of investor to firm and back must be closed.
Dividends are declared or announced by the Board of Directors.
The
shareholders of record on the record date receive the payment.
Since it
takes a while for the firm to record the new investors as owners, 3
days
before the record date is the ex-dividend date. Investors
who buy the
stock on the Ex-dividend date to not receive the dividend. For
this
reason the stock price drops by the amount of the dividend on the
ex-dividend date. (note in last week’s newsletter we saw that
many,
including Greenspan) are calling for a 1 day settlement day which would
push the ex-dividend back to just before the record date.)
Throughout much of the 20th century dividends were the main thing
investors looked for. Most firms paid dividends even when they had
to
raise new cash through offerings and debt sales to come up with the
cash
to do so. This view began to change after Modigliani and Miller
wrote
their famous 1961 dividend irrelevance paper. In this paper they
demonstrated that it should not dividends should not matter when the
firm
or the investors could each invest and earn the same amount on the
investment and there were no tax differences. The logic behind
this is
fairly straightforward: if the firm pays out cash, it has less to invest.
If you receive cash you have more to invest. Assuming that you
are both
investing in the same assets, it really doesn’t matter who is investing;
you or the firm.
Many of the assumptions of MM do not hold in the “real world.”
Thus, it
is worthwhile to examine what has happened since 1961.
Reasons for paying out large dividends:
1. Managers invest with their own best interests and not shareholders’
best interests at heart. Thus, a larger dividend may lower the
number of
poor investments that managers make. (This is a version of Jensen’s
1986
Free Cash flow theory.)
2. A bird in the hand is worth two in the bush. This hypothesis,
which
has been around since at least 1963 with the works of Gordon and Lintner,
reasons that investors will view dividend paying stocks as less risky
than
non dividend paying stocks.
3. Transaction costs. Some investors can not raise the money
they need
to live on and would rather receive dividends than to depend on selling
a
portion of their shares and paying high transaction costs.
4. Dividends act as a signal that managers can use to signal the financial
future of the firm. This comes from work by Lintner who found
that
managers are afraid to cut dividends and thus only raise dividends
when
they believe the dividend can be maintained at the new level.
(it must be
noted that this is at best a noisy signal).
Reasons for paying smaller dividends:
Taxes are by far the most important reason why firms have been paying
fewer dividends. There is a tax disadvantage of paying dividends.
This
is for three main reasons: investors must pay taxes on the dividends
when
the dividends are paid (capital gains can be forestalled by not selling),
dividends come out of net income so the dividend is subject to double
taxation: taxed at the corporate level and at the investor level, and
finally dividends are taxed as ordinary income and not the lower capital
gains rate.
Empirically, when companies announce a dividend initiation or increase,
the stock does increase in value. As would be expected, dividend
cuts are
associated with stock price drops.
Largely as a result of the tax-disadvantages of paying dividends, most
firms are not placing as much emphasis on dividends. In lieu
of dividends
many have decided to reinvest their earnings and/or do stock buybacks
(which have increased dramatically in the past two decades).
Other things about dividends that you should know:
* Dividends received by corporations are not fully taxed. To
avoid the
problem of triple taxation, the 70% of dividends received by corporations
are exempt form taxation.
* Many Firms have Dividend Reinvestment Plans (known as DRIPs).
These
allow the investor to purchase new shares with the dividend (usually
at a
discount).
* Stock Dividends are really small stock splits. In lieu of cash
you
receive more shares, but of course the stock price falls.
* The payout ratio is the dividend per share divided by the Earnings
per
Share.
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