Why Dividends Actually Might Be Relevant

by: Safraner Investment

In a previous and much disputed article I argued that dividends are irrelevant. Not meaning that they are evil or wrong, just that they do neither add nor subtract value from your investment (before taxes are considered). Like a chocolate or vanilla dilemma, they seem a question of preference.

Companies are worth - so the theory goes - as much as the present value of their future cash-flows. After some math, this reveals that the sources of value for any company are its return on invested capital and its growth. No more and no less.

Analysts then devote long hours to grasp the past history of companies, as shown by their financial statements, in order to develop a sense of what their future might look like in terms of growth and return. In a word: to develop a sense of their value.

Seasoned analysts, on top of this, will usually take financial statements with a pinch of salt - if not more. In the real world, statements can often be gently massaged by expert accountants or business practices, up to a level that makes unbundling the real prospects for a company a complex task. Frequently the hard work for an analyst begins when the number-crunching exercise ends.

Cash is favored by investors over earnings as a consequence of the above: cash is harder to simulate and it is the ultimate source of value. Cash is also what dividends are paid from and many investors appreciate this feature of dividends: they are paid with real money. Even the best among accountants can't make that up, no matter how much we wish they could!

Suspicious investors might then have a good reason then to prefer companies that distribute dividends: if nothing else, they provide at least a regular checkpoint that something real might be happening behind the scenes after all. Unfortunately, if fraud is the concern, Ponzi schemes often look attractive not because they manage never to show the real thing, but precisely because they do show it regularly and generously.

Nevertheless, the fact is that, once a company has set its investment policy, its dividend policy becomes only a choice of financing strategy. When accountants can't create cash, they can often borrow it, so dividends may come at the expense of leverage, that is, at the expense of swapping shareholders rights for creditors rights.

In the end, company value is ultimately in the source of funds (return on investment, earnings growth…) and not in the use of funds (dividends, buy-backs, de-leveraging…). If income investors prefer the dividend stable stream of cash, then that is a perfectly valid choice. But as shown in my previous article, they could achieve the same result by selling stock, did the company not pay dividends.

To put this in the words of Merton H. Miller:

The academic consensus is that dividends don't really matter very much. The market does not, and should not be expected to, pay premium prices for firms adopting what are sometimes called "generous "dividend policies […] In sum, much of the belief that dividends are terribly important is basically a confusion of the firms dividend policy with its investment policy

But then to the title of this article, why do dividends seem so relevant "in the real world"? Why do markets typically react positively to dividend increases even if earnings or cash-flows have been temporarily heading south?

Readers who abhor theory need not press the eject button if I say that a potential answer to this enigma may lie in the theory of rational expectations. Miller himself summarizes it as this:

what matters in […] policy making […] is often not so much what actually happens as the difference between what actually happens and what was expected to happen

A dividend hike that beats market expectations will make investors suspect that management sees earnings rising even if no such rise has been announced or reported (remember reported earnings make an uncertain picture). The market price will react positively to dividend hikes not so much because the dividend went up, but because of the added expectation of earnings going up.

Equivalently, if an announcement comes below expectations, prices can suffer even if the dividend actually rose. What matters here is not how much dividends move, but how much their movement differs from expectations.

If Miller is right in his explanation, management could try to fool the market by announcing higher-than-expected dividends. That could work in theory, but would only set up higher expectations for the future. Sooner or later, management would be forced to either meet its self-imposed expectations or fail to meet them - and let the illusion crumble consequently.

This mechanism can explain why dividends seem so relevant to the market even if they are in fact irrelevant from a value perspective.

In a nutshell, dividends seem relevant to the extent that they send signals on the expectations of management about future earnings developments. As such, they offer an additional source of information to be considered by investors. Companies not distributing them, in a sense, are keeping investors blind.

Conclusion

From a company value perspective, once investment policy is set, dividend policy becomes a pure choice of financing strategy irrelevant to value.

Dividends may seem relevant in practice because they provide signals to the market on the expectations of management about future earnings. But what matters in the end is not dividends themselves but earnings, not how value is distributed to shareholders but how value is generated for shareholders. After all, investors willing to cash their investments can generate regular income by receiving dividends in the same fashion that they can be generated it from selling a portion of their stock.

So all in all, dividends are a question of preference. If a particular investor finds psychological reassurance - as I do - in receiving regular dividends, then dividend payers are a good choice for him. Success is hard enough in the market to shoot for it against our own emotions.

On the other hand, long term value investors can be as well rewarded by investing in companies that are undervalued compared to their fundamentals, no matter what their dividend policies are.

My personal choice, if that is of any relevance, is heavily biased towards high quality dividend payers. I devote a smaller slice of my portfolio to non payers with a solid track record of value creation. I also invest in different market indexes as a way to diversify my portfolio.

Final note: for interested readers, the quotes in this article have been extracted from this paper

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.