Long-Term Horizon, Portfolio Strategy, Macro
Contributor Since 2009
Dividends are not a positive factor in deciding whether or not to own particular stocks. That’s because dividends reduce the value of the underlying shares by the amount of the dividend. Suppose there exists a corporation that consists of a broken hot dog cart, with no regular place to sell hot dogs, and it has no other assets or liabilities. This company would not be worth much. But, suppose this corporation had $1 million dollars in its corporate bank account. Then, the company would be worth nearly $1 million. A person could do very well buying the company for less than $1 million, then disposing of the hot dog stand, closing the business, then withdrawing the $1 million from the bank account. But, if the current owner of this business paid out in dividends to herself the $1 million that was in the bank account, the business would be left with roughly zero value. So, the business is worth a great deal before the dividend, but not much afterward. Likewise, publicly traded stocks trade at prices set by investors’ evaluation of what the company is worth. The value of any company depends on its earnings, prospects for the future, assets and liabilities. Cash is part of the assets. And each dividend paid out translates into either more borrowing or less cash on the balance sheet.
Clearly, dividends do NOT provide a cushion under the stock price, as investors have found out painfully in recent years. And their payment has further weakened many companies already suffering from declining profits.
However, paying dividends does make great sense when a financially strong company earns more than it needs to use for working capital or for its capital budget. Here, the cash would just continue to grow. An example would be Microsoft (MSFT). Better to pay out the excess cash in a dividend to shareholders (your maximum tax rate on dividends is only 15%) than to let it pile up in the company treasury while incurring the high corporate income tax rate on the interest that it earns.
Dividend payments are fine for companies that are strong, financially. Examples are: Diamond Offshore (DO), Intel (INTC), Lockheed-Martin (LMT), Lowe's (LOW), Microsoft (MSFT), Johnson & Johnson (JNJ), 3M Company (MMM), Stryker (SYK), Wal-Mart WMT), and Walgreen (WAG). But cash is part of a company’s assets. Once paid out in a dividend, that cash is no longer part of what the company is worth. The bottom line: dividends are efficient and appropriate when companies have excess cash, but a dividend payment does not increase shareholder value because it subtracts a like amount from the what the company is worth, which is expressed in its stock price. Therefore, investors should not consider a dividend as a positive factor, in and of itself, in evaluating whether or not to own a particular stock.
Disclosure: My clients or I own shares in: Intel (INTC), Microsoft (MSFT), Lockheed-Martin (LMT), Lowe's (LOW), Johnson and Johnson (JNJ), Stryker (SYK), 3M Co (MMM), Wal-Mart (WMT), and Walgreen (WAG).