Thu, 03 Jun 2004

Dividends

Dividends and capital gains are now taxed at the same (low) rate. Heretofore, capital gains (an increase in the value of a stock) have been taxed at a lower rate than dividends (corporate earnings distributed to stockholders). This led corporations to prefer capital gains over dividends. Over time, companies have ceased to pay out dividends because they can deliver more value to stockholders by increasing the price of their stock. This has led to some poor practices. Paying dividends is a good thing, for several reasons.

First, because capital -- deferred expenditures -- is the only thing that makes society wealthier. Even if you think we should soak the rich, that doesn't work if there are no rich to soak. If you think that a rising tide lifts all boats (which is a code phrase for "Don't tax the rich; the rich create more jobs by spending their money than the government will.") then you definitely want society to be wealthier. Taxing dividends is a form of capital consumption.

Second, because dividends keep a company honest. Enron got into trouble because they falsified earnings. The value of a company is based on its earnings. By creating book (accounting) earnings, they increased the value of their stock. This encouraged people to invest more money in Enron. If, instead, investors demanded dividends, Enron's duplicity would have been discovered sooner. False earnings cannot be turned into cash and paid out.

Update: Marc points out that false earnings can be turned into debt. He's right. For example, a company committing fraud can sell more stock based on their false earnings. This amounts to a classic Ponzi scheme -- paying off early investors with new investment. Or they could convince a bank, on the strength of their earnings, to give them a line of credit. Let's say, as a weaker form of my point, that having to pay dividends eliminates the ranker forms of fraud, but not all of them.

Third, because the stockholder has chosen wisely by purchasing a stock that produced earnings. Obviously, some stocks do not generate the earnings that people expect. Perhaps the marketplace of the business is declining (think buggy whips), perhaps the company is badly managed, perhaps the company has simply been out-competed by a more efficient company. The fact that the stockholder chose wisely says that the stockholder should be given a chance to do it again. She should be paid a dividend, so that she can use her wisdom to purchase more of the same stock, or another stock even more likely to generate earnings.

Fourth, because corporate managers have a built-in incentive to grow the company in opposition to paying out dividends. A bigger company is expected to pay higher salaries to the top managers because of the increased responsibility. These managers tend, then, to engage in mergers which turn out to be unprofitable. The majority of purchasing companies pay too much for the purchased company. If, on the other hand, the company pays a dividend, that reduces the amount of available cash for frittering-away purposes.

Classic investment advice, such as that in Benjamin Graham's book _The Intelligent Investor_ advises investors to put a premium on stocks that consistently pay a dividend. Hopefully we can return to the days when companies that are pleasing their customers can also please their stockholders by paying them a dividend.

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