Why Dividends Suck - Tilted Forum Project Discussion Community

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?

eribrav · 01-11-2007, 04:29 PM

Quote:

Originally Posted by Yakk

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?

First off, in the US, dividends are not taxed at a high rate. They're taxed at a low rate. I don't know the laws in Canada.

Second, buybacks and earnings do not determine share price. The market does. There are many companies that are doing huge buybacks, and their stock price has done nothing. Bubkus. The shareholders would be much better off with the dividends.

Third, when you sell stock you do not sell it to the company. You sell it to someone else in the market.

Fourth, growing companies make their shareholders money via appreciation of the stock price, not via dividends. Have you pondered why a company making money hand over fist, with huge cash reserves (like Google) pays no dividend? It's because management can use the money to grow the business, which ultimately can make even MORE money for the shareholders. Contrast that with companies like Exxon or BP. They are also making money hand over fist but there is a finite amount of drilling and exploration that can take place. In that case they are better off distributing profits to shareholders. That is in essence the difference between a value/dividend stock and a growth stock.

DDDDave · 01-11-2007, 06:51 PM

Then there are companies like Bank of America which pays a hefty dividend, grows its business every year and buys its own stock back regularly.

Yakk, you kind of gave a simplified description for a very complex transaction.

Utilities are an example of stocks whose main goal is to pay dividends. They produce steady streams of income and don't particularly try to 'grow their business'.

Taxes are an entirely different discussion. Dividends paid into a tax-free account (IRA) are not taxed until taken out. The tax rate is unknown until that time.

Yakk · 01-12-2007, 08:19 AM

Yes, the act of the stock buyback is factored into the price of the stock even before the act occurs.

Compared to capital gains, dividends are taxed at a high rate.

The following situation is simplified math with unrealistic growth rates.

Take two companies -- A and B. Both are companies worth 1 billion$ as a whole and have 10 million outstanding stocks initially. (each stock is worth 100$).

Both generate 50$ million in profit every year, and have nothing better to do with it than pass it on to shareholders.

Company A issues a dividend every year.
Company B buys back 50$ million in stock every year. This is 5% of the outstanding shares.

Both actions result, on average, in 50$ million being passed from the hands of the company to the hands of shareholders.

At the end of 10 years, both companies are still worth 1$ billion dollars. The first company still has 10 million shares. Each share is worth 100$.

The second company has bought back 5% of it's shares over the last 10 years. That means it only has about 6,000,000 shares outstanding. Each share, given that the company is worth 1$ billion, is worth 167.02$.

The investor in company A chooses to use his dividends to buy shares. He has a 20% marginal tax rate on the dividend income. After 10 years, he owns 1.4802 shares for every share he owned initially -- so his 100$ initial investment is now worth 148.02$.

The investor in company B then sells his share. 67.02$ in capital gains, taxed at 20% marginal, is 53.62$.

Notice that 48.02$ in post-tax profit from the owner of Company A is less than the 53.62$ in post-tax profit the owner of Company B has.

Note that after a few years of doing this, Company B would do a stock split to keep the value of a single share from getting out of hand. But issues like stock splits aren't that important -- they don't change the underlying asset being talked about.

Now, as mentioned, the situation is more complex than this. Tax shelters, regulatory paperwork, and other rules that differentiate between the various ways of moving money from corperation to stockholder change the landscape. And the price of stock isn't determined by how useful the stock is to you, but rather how useful the stock is, on the margin, to a new buyer.

But effects like the above is one reason why dividends have been falling out of favour more and more.

The power to defer taxation that most areas grant to capital gains is ridiculously powerful, and there are ways you can pass the value of stock onto stockholders via capital gains rather than traditional methods.

eribrav · 01-13-2007, 06:42 AM

Quote:

Originally Posted by Yakk

Yes, the act of the stock buyback is factored into the price of the stock even before the act occurs.

Compared to capital gains, dividends are taxed at a high rate.

The following situation is simplified math with unrealistic growth rates.

Take two companies -- A and B. Both are companies worth 1 billion$ as a whole and have 10 million outstanding stocks initially. (each stock is worth 100$).

Both generate 50$ million in profit every year, and have nothing better to do with it than pass it on to shareholders.

Company A issues a dividend every year.
Company B buys back 50$ million in stock every year. This is 5% of the outstanding shares.

Both actions result, on average, in 50$ million being passed from the hands of the company to the hands of shareholders.

At the end of 10 years, both companies are still worth 1$ billion dollars. The first company still has 10 million shares. Each share is worth 100$.

The second company has bought back 5% of it's shares over the last 10 years. That means it only has about 6,000,000 shares outstanding. Each share, given that the company is worth 1$ billion, is worth 167.02$.

The investor in company A chooses to use his dividends to buy shares. He has a 20% marginal tax rate on the dividend income. After 10 years, he owns 1.4802 shares for every share he owned initially -- so his 100$ initial investment is now worth 148.02$.

The investor in company B then sells his share. 67.02$ in capital gains, taxed at 20% marginal, is 53.62$.

Notice that 48.02$ in post-tax profit from the owner of Company A is less than the 53.62$ in post-tax profit the owner of Company B has.

Note that after a few years of doing this, Company B would do a stock split to keep the value of a single share from getting out of hand. But issues like stock splits aren't that important -- they don't change the underlying asset being talked about.

Now, as mentioned, the situation is more complex than this. Tax shelters, regulatory paperwork, and other rules that differentiate between the various ways of moving money from corperation to stockholder change the landscape. And the price of stock isn't determined by how useful the stock is to you, but rather how useful the stock is, on the margin, to a new buyer.

But effects like the above is one reason why dividends have been falling out of favour more and more.

The power to defer taxation that most areas grant to capital gains is ridiculously powerful, and there are ways you can pass the value of stock onto stockholders via capital gains rather than traditional methods.

Unfortunately, you've simplified things to the point of absurdity. There is no validity to what you are saying.

Please back up the statement that "dividends are falling out of favor". How many companies have recently stopped paying dividends? Now look up how many have started paying them. What did you find?

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.

01-11-2007, 06:51 PM	#3 (permalink)
DDDDave Addict Location: Sarasota	Then there are companies like Bank of America which pays a hefty dividend, grows its business every year and buys its own stock back regularly. Yakk, you kind of gave a simplified description for a very complex transaction. Utilities are an example of stocks whose main goal is to pay dividends. They produce steady streams of income and don't particularly try to 'grow their business'. Taxes are an entirely different discussion. Dividends paid into a tax-free account (IRA) are not taxed until taken out. The tax rate is unknown until that time. __________________ I am just a simple man trying to make my way in the universe... "Go confidently in the direction of your dreams. Live the life you have imagined." - Thoreau "Nothing great was ever accomplished without enthusiasm" - Emerson

01-12-2007, 08:19 AM	#4 (permalink)
Yakk Wehret Den Anfängen! Location: Ontario, Canada	Yes, the act of the stock buyback is factored into the price of the stock even before the act occurs. Compared to capital gains, dividends are taxed at a high rate. The following situation is simplified math with unrealistic growth rates. Take two companies -- A and B. Both are companies worth 1 billion$ as a whole and have 10 million outstanding stocks initially. (each stock is worth 100$). Both generate 50$ million in profit every year, and have nothing better to do with it than pass it on to shareholders. Company A issues a dividend every year. Company B buys back 50$ million in stock every year. This is 5% of the outstanding shares. Both actions result, on average, in 50$ million being passed from the hands of the company to the hands of shareholders. At the end of 10 years, both companies are still worth 1$ billion dollars. The first company still has 10 million shares. Each share is worth 100$. The second company has bought back 5% of it's shares over the last 10 years. That means it only has about 6,000,000 shares outstanding. Each share, given that the company is worth 1$ billion, is worth 167.02$. The investor in company A chooses to use his dividends to buy shares. He has a 20% marginal tax rate on the dividend income. After 10 years, he owns 1.4802 shares for every share he owned initially -- so his 100$ initial investment is now worth 148.02$. The investor in company B then sells his share. 67.02$ in capital gains, taxed at 20% marginal, is 53.62$. Notice that 48.02$ in post-tax profit from the owner of Company A is less than the 53.62$ in post-tax profit the owner of Company B has. Note that after a few years of doing this, Company B would do a stock split to keep the value of a single share from getting out of hand. But issues like stock splits aren't that important -- they don't change the underlying asset being talked about. Now, as mentioned, the situation is more complex than this. Tax shelters, regulatory paperwork, and other rules that differentiate between the various ways of moving money from corperation to stockholder change the landscape. And the price of stock isn't determined by how useful the stock is to you, but rather how useful the stock is, on the margin, to a new buyer. But effects like the above is one reason why dividends have been falling out of favour more and more. The power to defer taxation that most areas grant to capital gains is ridiculously powerful, and there are ways you can pass the value of stock onto stockholders via capital gains rather than traditional methods. __________________ Last edited by JHVH : 10-29-4004 BC at 09:00 PM. Reason: Time for a rest.