Why Dividends Don't Matter

by: Steve Hassett

Dividends simply don’t matter – they are neither good nor bad. Still many investors prefer to invest in equities that produce a high dividend yield. Some prefer the income, while others believe that dividends are a financial component that creates value. Neither of these are good reasons for investing, since dividends are not necessary to create investment cash flow and don’t drive value.

Earnings Not Dividends Drive Value

Some suggest equity should be valued as the present value of dividend payments. One well known advocate of this approach is Nobel Laureate Paul Krugman, who said:

Now earnings are not the same as dividends, by a long shot; and what a stock is worth is the present discounted value of the dividends on that stock - period, end of story.[i]

Krugman is adamant that the only things that you should count in valuation are dividends and share repurchases. This is wrong in theory and wrong in practice. On the theoretical side, Franco Modigliani and Merton Miller posited in their famous article on the “irrelevance” of dividend policy, that it is the underlying expected earnings and cash flow of companies, not their dividend payouts that determines market values. Dividend policy does not impact valuation.[ii], [iii],[iv].

On the practical side, the RPF Model shows that earnings and interest rates drive the value of the stock market, not dividends. Dividend policy is a matter of capital structure in that companies use dividends to repatriate cash to shareholders or choose not to pay dividends in order to reinvest in their business. Some companies even borrow to sustain or increase dividends as part of a decision to include more debt in their capital structures, others just to sustain dividends in down year.

What if an investor desires a steady income?

Earnings Can Generate Investor Cash Flow without Dividends

Investors’ belief that they need dividend income is a behavioral issue and nothing more. If you had two companies, both earning $2 per share and trading at the same multiple and one paid half of its earnings in dividends, while the other paid no dividends, some investors would prefer the dividend paying company, since they would get $1 in income per share. The reality is that you can generate the same income by selling $1 of the non-dividend-paying company stock and, as I’ll demonstrate below, end up in the same place financially.

Yet many investors feel better if they generate cash flow through management’s decision to pay a dividend rather than having to actively decide to sell shares. Since the economic equivalence can be demonstrated this is a behavioral not an economic decision. (Under Kahneman and Tversky’s Nobel Prize winning Prospect Theory, this is considered a framing issue.)

Management’s decision to pay a dividend does not matter because shareholders can mimic the result of dividend by choosing to sell shares and therefore determine the time at which they receive cash. In other words, if they want their earnings distributed in cash, an investor can sell shares. Consider the example below for a company that has EPS of $2.00, growing at 8% per year. To keep things simple, we assume it trades at a P/E ratio of 20 throughout the period, so starting with earnings of $2 per share and a P/E of 20 it trades for $40 per share.

Two investors each hold 1,000 shares. Investor 1 holds all his shares throughout the period. Investor 2 makes his own dividend policy by selling shares equal to earnings – effectively mimicking a 100% dividend payout ratio. In the first year, Investor 2 held 1,000 shares. Since the company earned $2 per share, he needed to sell $2,000 worth of shares ($2 x 1000 shares) to create his “dividend,” so he sells 50 shares ($40/share x 50 shares) to reduce his holdings to 950 shares worth $38,000.

Equivalence of Selling Shares Instead of Dividends

Since we are assuming that earnings grow at 8% and the P/E is a constant, the share price also grows at 8%. If we assume that Investor 2 reinvests his distribution somewhere else, but also at an 8% return, the line “FV of Distributions” above shows their value in Year 5. It’s not a coincidence that the ending value of shares for Investor 1 and shares plus the future value of distributions in the final year for Investor 2 are both $54,420. Since the distributions earn the same rate of return as shares, they have to be equal. Differences only arise if either shares or reinvested distributions outperform one another. Dividends don’t matter!

Only if earnings growth is greater than the reinvestment rate of return, would Investor 1’s results outperform Investor 2’s results. For example, if the company grew earnings at a 20% rate during the period then stock price would increase at 20% per year, so investors would be better off maintaining their investment in the company rather than selling shares.

Likewise, if the company paid a dividend, then those shareholders who reinvested the dividend in the company would outperform those who took the cash. You see, it does not matter whether the company pays out cash through dividends or share repurchases, the results are the same; since public markets provide liquidity, shareholders determine whether they will reinvest profits or not.

Dividends Don’t Reduce Risk

One other argument is that dividend paying stocks are less risky. As measured by Beta, non-dividend payers in the S&P 500 are only slightly more risky with an average Beta of 1.19[v] versus 1.10 for the dividend payers. Even this difference is overstated since the non-dividend payers include companies like AIG (NYSE:AIG), SLM (NYSE:SLM), Titanium Metals (TIE), Sprint Nextel (NYSE:S) and Harmon International (NYSE:HAR), which have suspended dividends in the wake of financial struggles.

When Dividends Are Good

I am not saying that dividends are bad, just that they are not a driver of value and not necessary to generate income. While dividends are unnecessary for an investor to generate income, they are still valuable and worth incorporating in your investment consideration because they convey information about management philosophy. Rather than building a cash hoard dividends provide an important way for managers to return excess capital to shareholders. This is a good thing. Not only does this give shareholders discretion on reinvestment, it also removes the temptation for management to spend the cash on low value acquisitions and investments.

Similarly, maintaining a dividend projects an image of financial discipline and increasing a dividend projects confidence in future growth. While paying a dividend suggests that management believes that its cash flow exceeds its investment opportunities, hoarding cash probably sends the same message. One wonders why Apple (NASDAQ:AAPL) or Microsoft (NASDAQ:MSFT) or Intel (NASDAQ:INTC) need to hold $25 billion, $43 billion, $20 billion in cash respectively.

[ii] Franco Modigliani, Merton H. Miller, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business. 1961, vol. 34, no. 4.

[v] Analysis of data from I-Metrix.com by Hassett Advisors

Disclosure: Author long MSFT