I see many articles, comments and blogs on Seeking Alpha that stress the importance of dividends and suggest that the dividend decision by boards of directors is a very important one and that a high or increased dividend is a good thing. Just today, someone wrote "Earth to GE: Boost Your Dividend." You can read this article at seekingalpha.com/article/176927-earth-to....
I could not disagree more.
There is a long-standing controversy in the investment community about the relevance of dividends as opposed to earnings as the true source of value of a company's common stock. However, economists Merton Miller and Franco Modigliani debunked the dividend argument in the 1960s with their Miller-Modigliani Financial Theory.
As the home page of Seeking Alpha today demonstrates, the love of dividends persists. Why? I can only attribute it to illiteracy about numbers (called "innumeracy") and a lack of knowledge of accounting.
In the course of a firm's conducting business, that firm basically does only two things: it generates revenues, and it incurs costs. The difference -- the excess -- is called cash flow (if cash accounting is used) or earnings (if accrual accounting is used). Dividends are paid out of these earnings or cash flow. If dividends and new investment are greater than earnings, the firm may have to issue new equity, which is dilutive to existing shareholders.
If the firm has a stock price selling below its true value, or if it has investment opportunities where the net present value (NYSE:NPV) of the investment is positive, the firm should use those earnings to repurchase shares or invest in new projects that have a positive NPV. By doing either of these, the firm INCREASES its value by retaining earnings instead of paying them out as a dividend. Repurchasing its own stock increases the percentage of the company that each existing shareholder owns. Investing in existing or new businesses that are profitable, i.e., have a positive NPV and high return on investment allow the firm to make more money with the money it did not pay out in dividends. These are rational managerial decisions. Paying dividends is seldom rational and often just a palliative for naive shareholders. If those shareholders need cash, they would be better off selling off judiciously small amounts of stock at the more favorable long-term capital gains rate.
As for GE, nothing could be more value destroying for the firm than a dividend increase. GE should not merely have cut its dividend, it should completely eliminate it! Mr. Immelt, drop the dividend entirely and buy back more of your own shares and invest in high return businesses!
The dividend discount model has been discredited in most academic circles. The dividend irrelevancy argument suggests that current stockholders are not better off -- or worse off -- receiving a dividend. A company should not pay a dividend except when the firm has poor management that makes bad investment decisions with the retained earnings, or when management has a lack of positive NPV investment opportunities.
Dividends are not a tax-efficient way to return cash to taxable shareowners. If you are a taxable investor, you pay a hefty (usually 35% or higher) tax on dividends received. If instead, you let the company buy back its own shares, you effectively get that dividend in the form of increased ownership percentage -- without the accompanying tax liability.
The founder of Seeking Alpha, David Jackson, in a great article opposing dividends and written fully four years ago (https://seekingalpha.com/article/616-why-dividend-paying-stocks-are-a-mistake) asked the same question: why do investors like dividends?
I simply do not know why. There are strong tax reasons to avoid paying dividends. There are deceptive signaling reasons why management likes to announce dividend payments and dividend increases. That is frequently misleading. There is something called the "information content of dividends hypothesis" which suggests that management pays a dividend or increases a dividend because it has better information about the future of the firm.
For most taxable shareowners of most profitable companies, paying dividends is unwise. Given how uneducated shareholders are, the paying of dividends strikes me as a kind of bribe and an exploitation of the ignorance of a firm's shareholder base. An intelligent shareholder base, such as those of Berkshire Hathaway (BRK.A, BRK.B), know that they are far better off if the firm retains the earnings and reinvests them in high-return businesses. [Note that Berkshire's own love of dividend-paying investments such as Goldman and GE stem from the favorable tax treatment that corporations get from preferred-stock dividends, namely that federal tax law requires corporations to pay tax only on 30% of a preferred stock dividend, while individual investors must pay tax on all 100% of the preferred dividend. This means that fully 70% of the dividend that Goldman and GE pays Berkshire is tax free. Mr. Buffett knows how to use tax laws to his advantage].
Paying a dividend is to me a sign of management failure and/or bribery and exploitation of shareholder ignorance. Attention all managers: if your ROI is high, if a new project has a positive NPV, or if your stock is underpriced, PLEASE! Don't send me a dividend check: reinvest in the high return businesses or use the retained earnings to buy back as much of your own stock as possible.
Now you know why I hate dividends -- and why you should too.
Disclosure: Long BRK.A and BRK.B. Long GE call options