This is my final piece on dividends (at least for a little while). Please bear with me.
In a now-famous commencement speech in 2005, writer David Foster Wallace opened with a parable.
Two young fish are swimming along and meet an older fish swimming the other way. The older fish nods at the pair and says, ‘Morning, boys, how’s the water?’
The two youngsters swim on for a bit and then ‘eventually one of them looks at the other and goes, “What the hell is water?”’
What was Foster Wallace getting at with the parable?
‘The immediate point of the fish story is merely that the most obvious, ubiquitous, important realities are often the ones that are hardest to see and talk about.
‘Stated as an English sentence, of course, this is just a banal platitude — but the fact is that, in the day to day trenches of adult existence, banal platitudes can have a life-or-death importance.’
So, what the hell does this have to do with dividends?
The dividend puzzle
Dividends are an obvious and ubiquitous part of the investing landscape.
But dividends are also important realities whose existence is taken for granted or even looked over.
If, like the young fish, investors were to ask, ‘What the hell are dividends, anyway?’, they’d find the answer more difficult than the ubiquity of dividends would imply.
Famous economist Fischer Black queried the nature of dividends in his widely cited article ‘The Dividend Puzzle’, where he began by asking two questions: why do firms pay dividends? And why do investors care?
Black’s article famously ended on an ambiguous note, saying:
‘I claim that the answers to these questions are not obvious at all. The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together.’
Enough thinking has been done on these questions to yield multiple Nobel Prizes.
Like the Nobel Prize for Economics awarded to Franco Modigliani and Merton Miller for their work on the irrelevance of capital structure…and dividends…to shareholder value.
Dividends are not a free lunch
The key to understanding Miller and Modigliani is the fact that a dollar paid in dividends is a dollar less to the firm but a dollar more to the shareholder.
From the shareholder’s perspective, this is a wash. Stephen Penman, finance professor at Columbia, explains this further (emphasis added):
‘When a firm pays out a dividend, the share price drops as one would expect; paying out a dollar means the firm is worth a dollar less. But the shareholder is no worse off; he or she has a dollar less of value in the firm but a dollar in hand. This is sometimes referred to as the dividend displacement property: Paying dividends displaces (reduces) value in the firm but leaves the shareholder no worse off. Now consider the payment of future dividends. If a firm pays dividends for three years, the price at the end of three years is displaced by the dividends; if a firm pays no dividends, the price is not displaced. But a lower price with higher dividends does not change the present value of the cash flows from lower dividends but a higher price.
‘This property is called the dividend irrelevance property. It is also called the Miller and Modigliani (M&M) proposition, after the professors who had the insight. The idea was awarded a Nobel Prize, and it stands as one of the foundational principles of modern finance. Value is not affected by dividend payout policy.’
We can simplify M&M’s proposition by reference to our personal finances.
If you paid out all your surplus cash to family, friends, charities, and casinos, your net worth would either flatline or decrease.
Similarly, if a company pays out its free cash flow as dividends, its asset base shrinks proportionately.
The decrease in cash — and the forgone opportunities at reinvestment — must be reflected in the share price.
That’s why stocks fall when they trade ex-dividend or when they make out a hefty special dividend.
Here are Modigliani and Miller in their own words:
‘An increase in current dividends, given the firm’s investment policy, must necessarily reduce the terminal value of existing shares because part of the future dividend stream that would otherwise have accrued to the existing shares must be diverted to attract the outside capital from which, in effect, the higher current dividends are paid.’
Fischer Black summarised the thinking of M&M in a lucid way by posing a scenario.
Would you rather have $2 today, and a 50% chance of $54 or $50 tomorrow? Or would you prefer to have nothing today and have a 50% chance of $56 or $52 tomorrow?
The expected value of both choices is the same, so would you really prefer one to the other?
Black responds on your behalf:
‘Probably you would not. Ignoring such factors as the cost of holding the $2 and one day’s interest on $2, you would be indifferent between these two gambles. The choice between a common stock that pays a dividend and a stock that pays no dividend is similar, at least if we ignore such things as transaction costs and taxes.
‘The price of the dividend-paying stock drops on the ex-dividend date by about the amount of the dividend. The dividend just drops the whole range of possible stock prices by that amount. The investor who gets a $2 dividend finds himself with shares worth about $2 less than they would have been worth if the dividend hadn’t been paid, in all possible circumstances.
‘This, in essence, is the Miller-Modigliani theorem. It says that the dividends a corporation pays do not affect the value of its shares or the returns to investors, because the higher the dividend, the less the investor receives in capital appreciation, no matter how the corporation’s business decisions turn out.’
But don’t dividends signal something?
But surely dividends mean something?
A company that institutes a dividend payout is telling the market it has confidence in its long-term cash-generating ability.
That should warrant a premium, no?
Here’s finance professor Aswath Damodaran explaining the signalling power of dividends in his Applied Corporate Finance:
‘By increasing dividends, firms create a cost to themselves, because they commit to paying these dividends in the long run. Their willingness to make this commitment indicates to investors that they believe they have the capacity to generate large, positive cash flows in the long run. This positive signal should therefore lead investors to reevaluate the cash flows and firm values and increase the stock price.
‘Decreasing dividends is a negative signal, largely because firms are reluctant to cut dividends. Thus, when a firm takes this action, markets see it as an indication that this firm is in substantial, long-term financial trouble. Consequently, such actions lead to a drop in stock prices.’
Modigliani and Miller have an answer for this too.
The M&Ms agree dividends relay information about management’s view of future profit prospects.
But they quibble with cause and effect (emphasis added):
‘That is, where a firm has adopted a policy of dividend stabilization with a long-established and generally appreciated “target payout ratio”, investors are likely to (and have good reason to) interpret a change in the dividend rate as a change in management’s views of future profit prospects for the firm.
‘The dividend change, in other words, provides the occasion for the price change though not its cause, the price still being solely a reflection of future earnings and growth opportunities. In any particular instance, of course, the investors might well be mistaken in placing this interpretation on the dividend change, since the management might really only be changing its payout target or possibly even attempting to “manipulate” the price. But this would involve no particular conflict with the irrelevance proposition, unless, of course, the price changes in such cases were not reversed when the unfolding of events had made clear the true nature of the situation.’
In any case, whether causal or collateral, dividends hold important informational value.
In a world of imperfect information and uncertainty, dividends relay vital clues to shareholders about management’s expectations of long-running earnings power.
By the way, if I haven’t bored you already and you’re still interested in dividends, check out Greg Canavan’s new free report outlining six stock ideas he thinks offer both income and growth potential!
Regards,
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Kiryll Prakapenka,
Editor, Money Morning
