Carnival was one of the many pandemic-hit companies that paused its dividend.
Photo: mike blake/ReutersIn June, I wrote an article in The Wall Street Journal, decrying the way investors—and companies—treat dividends.
The article generated a lot of questions, and I’ll answer 12 of them here.
To recap: I argued that companies and investors are hurt by the current approach to dividends, which considers them as largely inflexible. Because of that, a company first maintains last year’s dividend, and then invests out of the remaining cash. As a result, companies may destroy significant value by turning down value-creating investments to maintain the dividend.
By contrast, if dividends were more flexible, a company would first take all profitable investments, and then pay out the remainder to shareholders (or retain it as a cash buffer). This is indeed the current approach to share repurchases—the flexibility of such buybacks has allowed many companies to scrap them in the pandemic and preserve cash.
Note that the article argued for flexible dividends, not no dividends. Indeed, rigid dividends might lead to lower dividends. If the company has spare cash, it might not increase the dividend, because it will be “committed” to the new dividend level. The commitment isn’t a legal one, but a market expectation: If it subsequently cuts the dividend (e.g., because the economy weakens), its stock price will plummet. Thus, it inefficiently holds on to the cash.
Now, on to the specific questions (or contentions) that readers offered:
1. You argued that dividends aren’t necessary to provide liquidity to shareholders, because they can simply sell their shares to create liquidity—and can do so at a higher price if the company hasn’t paid out a dividend. But this argument ignores taxes.
Taxes would only strengthen the argument, as the dividend tax rate typically exceeds the capital-gains tax rate. Thus, it’s tax-efficient for investors to obtain liquidity through selling shares.
2. You advocate returning capital through buybacks rather than dividends. But CEOs use buybacks to artificially hit earnings per share bonus targets.
This isn’t backed up by evidence. A study that I did with PwC for the U.K. government found that not a single U.K. FTSE 350 company used share buybacks to hit a bonus target between 2007 and 2016. U.S. research discovered that CEOs do take actions to hit bonus targets, such as cutting R&D, but buybacks aren’t one of them.
3. CEOs buy back stock at inflated prices, destroying shareholder value.
Again, this concern can be evaluated with evidence. A seminal 1995 paper found that U.S. companies that buy back stock outperform their peers by 12% over the next four years—they do so at depressed, not inflated prices. An updated and expanded 2019 study showed that the original results continue to hold, not only in the U.S., but globally.
These results are average results. It might be that some CEOs are buying back shares at inflated prices. What else can a company do if it’s stuck with excess cash and its stock price is high? This highlights the value of flexible dividends. Under rigidity, the company is unwilling to increase dividends due to the commitment created, so it might indeed repurchase inflated stock.
Dividends are good for investors
4. I accept that the stock price falls when a company pays a dividend. But, the stock price is affected by so many other factors. So, the initial fall is irrelevant.
The stock price is indeed affected by many factors. However, the dividend reduces the “baseline” level of the stock price; future changes are now off a lower base.
Assume the current stock price is $10. Depending on interest rates, irrationality etc., it has a 50% probability of rising by 50% (to $15) by year end, and a 50% probability of falling by 40% (to $6). If the company pays a dividend of $1, it falls to $9. The year-end stock price will still be affected by interest rates and irrationality. It could rise by 50% to $13.50, or fall by 40% to $5.40. In both cases, the stock price is lower than without the dividend.
Let’s revisit the analogy in the original article. Paying a dividend is like withdrawing cash from an ATM. It gives you cash in hand but reduces your bank balance. It’s true that your year-end balance will be affected by your bonus at work and household expenditure. But, irrespective of these factors, your year-end balance will be lower with the withdrawal than without it.
5. Dividends are safe. Keeping the money in the company is risky—as you’ve just admitted, the stock price is affected by many other factors.
This is the “bird in the hand” fallacy, disproved in 1979. Here’s the intuition. Reinvesting the $1 is indeed risky, but you get a return for that risk. In the above example, the expected year-end value is 50% × $13.50 + 50% × $5.40 = $9.45. Without the dividend, it was $10.50, which is $1.05 higher. The reinvested dollar earns a 5% return.
What if the company has no good reinvestment opportunities? It should indeed pay out the cash, but through flexible dividends or buybacks. Under rigidity, companies may hoard cash, because they’re worried about creating a commitment.
6. You can reinvest dividends in other stocks, increasing your portfolio’s return.
A company that doesn’t pay dividends reinvests the cash within the firm, which lifts the company’s stock price as above. Many non-dividend-paying stocks have provided substantial total returns, such as Google parent Alphabet, Amazon. com, Facebook and Tesla.
7. Dividends are a safe income stream for investors. Stock prices move around all the time, but if a company is paying a $1 dividend, I’m guaranteed a $1 income.
Thinking about income and capital gains separately is a common mistake. It’s the total return that determines how much the investor’s wealth has changed, and thus how much he or she can “afford” to consume. That the dividend is guaranteed is irrelevant—it doesn’t guarantee you a (total) return. If the stock price falls from $10 to $6, a $1 dividend doesn’t mitigate the loss, as it would cause the stock price to fall further to $5. The total return is independent of the dividend.
Some investors may follow rules such as “consume only from dividends, don’t erode capital.” Such a rule doesn’t make sense. If the stock price has fallen, capital has been eroded even if the investor consumes only from dividends. What if the investor needs to pay bills (e.g., rent) regardless of his or her total return? Don’t dividends guarantee that the investor can pay the bills irrespective of what happens to the stock price? They do. But, investors can create such liquidity themselves by selling shares.
8. There’s time and effort involved in selling shares. It’s much more convenient to receive dividends.
There may indeed be investors with a unique preference for dividends, not total returns. Even if so, companies can’t create value by satisfying this clientele.
By analogy, some drivers like red cars; others like blue cars. Despite there being “red” and “blue” clienteles, a car company can’t profit by changing its color ratio, because the car industry is already producing the correct proportion to satisfy demand. Similarly, if there are dividend clienteles, some stocks could provide rigid dividends—perhaps mature companies that invest little—and dividend-seeking investors would hold them. Other companies can’t gain by offering rigid dividends to satisfy these investors, as their needs have already been satisfied. They may lose, since rigid dividends hinder investment.
9. Encouraging investors to sell shares to finance consumption encourages short-term trading, not long-term investing. This, in turn, induces short-termism among companies.
The ideal shares to sell are those with high short-term profits but poor long-term prospects. Short-term selling is critically different from short-termism—short-term sales can be driven by long-term information, and evidence suggests that they are. For example, Ford Motor hit record profits in 2015 and 2016, but investors sold because it wasn’t investing enough in self-driving cars and electric cars. On the other hand, dividends are inherently “short term” in that they withdraw funds from the company. Selling shares does not, because another investor buys them.
10. If I sell shares to finance consumption, I might sell in a down market—e.g., I might have sold at the start of the pandemic for a low price, and the market has since rebounded.
We shouldn’t extrapolate from one situation. The systematic evidence shows that stocks exhibit time-series momentum: After they’ve fallen recently, they tend to continue to fall. Moreover, if a company’s stock is indeed undervalued, a better use of excess capital is to buy back stock.
Dividends would otherwise be wasted
11. Your article assumes that, if dividends were not paid, the company would reinvest the cash profitably—but it may waste it. Dividends provide discipline and prevent overinvestment. They can only do this because they’re rigid—they commit the firm to pay out dividends in the future.
Debt is a superior way to prevent overinvestment. First, it provides more discipline as it’s a stronger commitment—a legal one rather than a market expectation. Second, debt is tax-advantaged, as interest is tax-deductible. Third, debt concentrates the CEO’s equity, giving him or her a larger stake in the firm and thus stronger incentives not to waste cash. Indeed, there is an industry that makes use of these benefits—private equity. Contrary to popular claims of asset stripping, research finds that it creates long-term value.
If the firm wishes not to take on debt, there may be a role for rigid dividends to provide discipline, which must be traded off against the cost of preventing valuable investment. These are the correct considerations to discuss when determining whether dividends should be flexible or rigid—not erroneous arguments that dividends are safe, or needed to provide a return to investors.
12. Dividends are a positive signal of a firm’s prospects. Since dividends are rigid, a company will only pay dividends if it’s sufficiently positive about future prospects that it thinks it can sustain the dividend.
Repurchases are also a positive signal as they’re an investment in your own company. Debt would be the strongest signal as it offers a stronger commitment.
Dr. Edmans is a professor of finance at London Business School and author of “Grow the Pie: How Great Companies Deliver Both Purpose and Profit.” He can be reached at reports@wsj.com.
Journal Report
- Insights from The Experts
- Read more at wsj.com/fundsreport
More in Investing in Funds & ETFs
Copyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8
"Many" - Google News
July 06, 2020 at 07:40AM
https://ift.tt/2CbBNUo
I Wrote, ‘Why Many People Misunderstand Dividends.’ Readers Had a Lot of Comments. - The Wall Street Journal
"Many" - Google News
https://ift.tt/2QsfYVa
Shoes Man Tutorial
Pos News Update
Meme Update
Korean Entertainment News
Japan News Update
Bagikan Berita Ini
0 Response to "I Wrote, ‘Why Many People Misunderstand Dividends.’ Readers Had a Lot of Comments. - The Wall Street Journal"
Post a Comment