Dividends and Equity Returns, Past and Future

When the historical total returns on stocks are referenced, for example, when thinking about the future of possible personal accounts associated with Social Security, the total return is typically described as being the sum of dividends and capital gains. These two components are then often treated as independent variables and hypothetical scenarios are produced that predict higher future dividend payouts in response to retirees' preference for spendable income. It appears that there is some belief that higher future dividends mean that higher future rates of return are more credible.

Unfortunately, the original description of total return as a simple sum of dividends and capital gains is invalid. It is not legitimate to add dollar amounts directly together if they occur at different times. The time value of money must be taken into account, as it is when the net present value of future cash flows is calculated.

When we look backward, an individual can list the amount and times of his dividends and take into account any re-investment of dividends that has occurred.

But to talk about a particular investment vehicle, whether it be a stock or a mutual fund, the only fair way to calculate the total return is to pretend that all cash dividends have been immediately, and costlessly, re-invested. This would result in all of the total return appearing in the capital gain and no change in the company share count. However, this still won't adjust for the tax treatment of dividends and won't result in a proper after tax return.

Cash dividends are not some bonus that a company provides, but rather a partial business (as opposed to stock) liquidation of the company with the proceeds being distributed proportionately to the existing shareholders.

The purpose of cash dividends is twofold :

First, to accomodate a desire for income by some, but not all, shareholders.

Secondly, to provide an advertising signal that management is confident that future cash flows of the company will be adequate to continue paying at least the current level of dividends without the necessity of a future reduction, a reduction which shareholders would tend to react to rather badly.

Cash dividends are a centuries old tradition, and much of the past justification for their use has effectively disappeared.

If shareholders want cash, all they have to do is sell a part of their holdings. Over the years, the transaction costs for such a sale have been sharply reduced. If the company wants to accomodate the shareholders who want cash, they can pay a share dividend, a fractional stock split of say 5%, and the shareholders could then sell the split shares that they have received. This would not annoy the shareholders that didn't want cash and would be an ownership dilution rather than a liquidation. [edit] In theory, there is no reason why the company itself can't follow a 5% stock split with an immediate effective buyback for the shareholders that elect cash.

The only real reason for cash dividends is as a last resort for the use of surplus cash.

The company revenues must go in sequence to expenses, internal investments, external investments, stock buybacks, and finally to cash dividends, so as to maximize shareholder value. Under this condition, cash dividends would tend to signal a lack of future investment opportunities and an overpriced stock with mediocre prospects.

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Patri, Congratulations on

Patri,

Congratulations on your change of status.

First, the value of a stock is the expected value of the future stream of dividends. If a stock is never going to pay dividends, how does it have value? Your split-and-sell has the same problem - why will people buy something that will never be worth anything? It’s like fiat money - but without the guns to make people accept it.

According to Schwab, I sold 1000 shares of a silver mining stock in August of 2004 for $13.80 per share after buying it in December of 2001 for $2.32 per share. It never paid a dividend, nor was it expected to. By your reasoning, its value was imaginary and hopefully you will be willing to give me a note for the IRS recommending that they accept my imaginary tax payments against an imaginary gain.

... the value of a stock is the expected value of the future stream of dividends plus the proceeds of a future liquidation event which may consist of the sale of your stock, the merger or acquisition of the company itself, or its actual cash liquidation.

If I hold a stock, I must believe that it is preferrable to selling the stock and re-investing the proceeds in some alternative investment. A cash dividend distribution forces me to make such an inferior re-investment.

If the management does not believe that the future prospects of the company warrant leveraging up my ownership of the company by buying back shares after alternate superior and/or necessary investment opportunities are exhausted, then it raises the question as to why I should continue to hold the stock. By giving me a cash dividend, the company is effectively claiming that I am better off in cash.

Regards, Don

I disagree. First, the value

I disagree.

First, the value of a stock is the expected value of the future stream of dividends. If a stock is never going to pay dividends, how does it have value? Your split-and-sell has the same problem - why will people buy something that will never be worth anything? It's like fiat money - but without the guns to make people accept it.

Second, this statement "cash dividends would tend to signal a lack of future investment opportunities and an overpriced stock with mediocre prospects." is not true. A company only has so many internal investment activities. It maximizes shareholder value by investing profits in any project which earns more than the market rate of return, and distributing all the rest so that the shareholders can earn the market rate of return. I don't see why its such a bad sign if the company doesn't have enough internal projects to use up all its cash.

In fact, I suspect that many companies perform internal investments that yield less than the market rate of return, and that's a bad thing. Really, cash should be going to the most profitable current prospects across every company in the world. It seems quite reasonable that those prospects might often be in another company.

An up-to-the-minute example

An up-to-the-minute example of the misconceptions of cash dividends -

http://www.iht.com/articles/2005/02/14/bloomberg/sxhonda.html

Honda plans to raise dividends and curb buybacks

"Increasing cash dividends is better for investors than buying back shares because they can see cash returns," said Yoshihiro Okumura, a general manager at Chiba-gin Asset Management.

"Higher dividends will benefit all investors by returning cash," said Koji Endo, an analyst at Credit Suisse First Boston in Tokyo. "Share buybacks help stabilize the share price, but not all investors participate and therefore most only have unrealized gains."

Regards, Don

The market expectation of

The market expectation of the value of its stream of dividends changed. That made the price change. But if there will never be a stream of dividends, so real money never comes out, the stock has no value.

So the fact that most of the technology stocks that I own have never payed a dividend and that I don't expect to ever pay a dividend makes them have no value?

But if cash never comes out of the shares, why would they be worth anything to anyone?

How about believing that in the future other people will find them more valuable than they do now?

According to Schwab, I sold

According to Schwab, I sold 1000 shares of a silver mining stock in August of 2004 for $13.80 per share after buying it in December of 2001 for $2.32 per share. It never paid a dividend, nor was it expected to. By your reasoning, its value was imaginary and hopefully you will be willing to give me a note for the IRS recommending that they accept my imaginary tax payments against an imaginary gain.

The market expectation of the value of its stream of dividends changed. That made the price change. But if there will never be a stream of dividends, so real money never comes out, the stock has no value.

Admittedly, there are other ways to get value out. The company could get sold, and the cash could be given to shareholders, or converted into stock in a company that distributes dividends.

But if cash never comes out of the shares, why would they be worth anything to anyone?