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Yakk · 01-11-2007, 02:38 PM

Suppose a company has 100$ million in shares, at 100$ per share, and makes a 5$ million profit.

Naively, it could simply issue a 5$ dividend. But currently, most companies don't do this.

Why? Because there are better options. Those dividends are taxed at a high rate, and they can avoid this, while still getting the money to the stockholders!

Suppose the company instead took the 5$ million, and used it to buy back shares of it's own company. The company is still worth about 100$ million, but there are 5% fewer shares out there.

So now each share is worth about 105$, and of the shareholders have (on average) 5$ million dollars (because, on average, 5$ million in shares where sold back to the company).

However, this money is in the form of capital gains. People who hold the stock get to defer the taxes until they sell, and those who sell get a lower tax rate than from dividends!

If you want your 5$ per share of profit, all you have to do is sell 1/20th of your shares back to the company.

Now, it actually doesn't work like this -- because the price of the stock already reflects the knowledge that the company is about to have about 5$ in profits, and they already know what the company is going to do with it.

But, basically, the wonderful distorting effects of different tax rates for different ways of making money makes dividends rather dumb!

...

Now, they aren't completely dumb. There are situations where dividends are the same as stock buybacks, and others where they are better than stock buybacks. But this is the essence of why companies have been issueing smaller and smaller dividends as time goes on.

Neat, eh?

01-11-2007, 02:38 PM	#1 (permalink)
Yakk Wehret Den Anfängen! Location: Ontario, Canada	Why Dividends Suck Suppose a company has 100$ million in shares, at 100$ per share, and makes a 5$ million profit. Naively, it could simply issue a 5$ dividend. But currently, most companies don't do this. Why? Because there are better options. Those dividends are taxed at a high rate, and they can avoid this, while still getting the money to the stockholders! Suppose the company instead took the 5$ million, and used it to buy back shares of it's own company. The company is still worth about 100$ million, but there are 5% fewer shares out there. So now each share is worth about 105$, and of the shareholders have (on average) 5$ million dollars (because, on average, 5$ million in shares where sold back to the company). However, this money is in the form of capital gains. People who hold the stock get to defer the taxes until they sell, and those who sell get a lower tax rate than from dividends! If you want your 5$ per share of profit, all you have to do is sell 1/20th of your shares back to the company. Now, it actually doesn't work like this -- because the price of the stock already reflects the knowledge that the company is about to have about 5$ in profits, and they already know what the company is going to do with it. But, basically, the wonderful distorting effects of different tax rates for different ways of making money makes dividends rather dumb! ... Now, they aren't completely dumb. There are situations where dividends are the same as stock buybacks, and others where they are better than stock buybacks. But this is the essence of why companies have been issueing smaller and smaller dividends as time goes on. Neat, eh? __________________ Last edited by JHVH : 10-29-4004 BC at 09:00 PM. Reason: Time for a rest.