In one respect the stock market has often baffled me. I understand what stock ownership in a private company means. And I even understand what stock ownership in a publicly traded low growth dividend earning stock means.
What I don’t understand is why a reasonably mature public stock that generates no dividend is worth anything to anybody. Ok that’s not quite true. I understand why a company might be strategic to another company and so, in that context, to have substantial value even if not producing revenue, or even profit. But owning a stock in the hope that someone else will see it as strategic ain't no way to manage a portfolio.
In the tech market, most companies are considered “growth” stocks, and so do not pay a dividend. As the most insane and absurd example, Microsoft only felt it appropriate to start paying a dividend in 2003. In the case of a no-dividend company, what you are doing when you buy their stock is absolutely nothing more than gambling that some other guy is going to think, in the future, that the given stock has more value than you believe it does today, probably based on some nebulous metrics. But if your intent is to hold that stock for a long period of time, how are you getting a return on investment if there is no dividend? As I see it, investing in publicly traded mature stocks that don’t offer a dividend is the most pure (and ridiculous) form of gambling.
As I see it, the stock market ought to work a lot more like private stock ownership. If you own stock in a private company, unless you are in a massive early stage growth phase, the value in owning the stock is that it generates revenue for you. A dividend. This is no different than how you should feel as the holder of a relatively mature private company.
The reason I started thinking about this is I, like everyone else, have been wondering where the bottom of the market is. And in tech, i.e. growth stocks, I have been wondering how you select a bottom for companies that pay nothing to their shareholders.
I think one of the repercussions of this crash is that at all but the earliest stage companies will have to consider a dividend strategy that makes sense not just for the companies but for their shareholders and the stock market as a whole. This may be the only real way of re-establishing underlying value for equities.
21 comments:
Agree completely!
It's like just hoping for the best, but you ain't taking the decisions on it...
Worst than gambling, actually...
You are clearly not an economist. If you want fixed income, buy bonds. No one buy stocks *only* for the dividend, you are always (whether you want it or not) also participating in a bet on the 'perceived current value of future profits'. That is indeed some sort of gamble, you are just hedging your bets a bit when you buy stocks in mature companies that dividends.
For an economist, companies should only start paying dividends (or alternatively, buy back their own stock) if they don't see ways to invest their income in ways that generate at least as enough profit to offset interest rates.
Note that tax regimes often differentiate between dividend income and growth in stock value, which skews the preference investors might have.
"You are clearly not an economist."
No. you are right. If people were following the kind of sober non-economist advice I have been dishing out here, instead of following the mainstream bull (in both senses of the word) strategies from "economists" the market would certainly look different than it does.
"No one buy stocks *only* for the dividend, you are always (whether you want it or not) also participating in a bet on the 'perceived current value of future profits'. That is indeed some sort of gamble, you are just hedging your bets a bit when you buy stocks in mature companies that dividends."
I did not say people buy or should buy companies only for dividends. The essence of my point is that companies that are not returning profits to shareholders in relatively mature markets are being valued primarily on smoke and mirrors. If a company grows wildly, but never pays out profits to shareholders, why is that stock more valuable than one that is not growing wildly but does, unless the high growth company is acquired?
The essence of your arguement is that there is some "magic" that happens when a company goes public that would/should cause you to think about it differently than the way a private company is valued. Aside from easier liquidity, I see no difference. The fact that the market makes such a huge distinction is illusory and I think this is another example of chickens coming home to roost from attempting to pretend there is a class of people that are just smarter than the rest of us that really "get it". The banking crisis has demonstrated that that just aint true.
"For an economist, companies should only start paying dividends (or alternatively, buy back their own stock) if they don't see ways to invest their income in ways that generate at least as enough profit to offset interest rates."
No offense, but thats ridiculous. Companies would pay dividends if it was necessary for their companies to have value in the public markets. You assumption is framed in the context of a market that has accepted that owning the stock has no cash flow benefits except at the very slow growth margins.
One of the things that is interesting is to hear VCs now talk about, effectively, dividends (not technically but effectively) as a partial exit vehicle for private companies in an environment where there are no IPOs. If private investors are thinking this way, certainly public investors should too.
The old "official" position on why someone should ever buy common stock in a company that doesn't pay dividends is "You are buying because you think they might pay dividends in the future" -- logically when the DO start paying them, the stock price would go up, since the shares would be more desirable.
Realistically, though, companies that currently don't offer dividends won't offer them in the future either, since large shareholders have other ways of extracting value from a company, and small shareholders will not be able to convince the board and officers to part with the money.
So what you're really buying is the fond hope that the company's inherent value will increase without dilution through issue of more shares.
Of course, if you buy something as insubstantial as hope and dreams, you have to expect salty tears when there is an economic downturn.
Unless there is a total collapse of the market, though, I really wouldn't expect that all public companies will have to start paying dividends. I mean, it could happen someday, but I wouldn't wait underwater.
Anonymous 2,
Well put.
My thesis here is that this whole circumstance just might be painful enough for even big institutional investors to rethink their valuation strategies. This all might have a serious sobering up effect.
That said, of course given human nature it is entirely possible things will return to the status quo with no long term effect.
Hank, I completely agree with your assessment.
The absence of dividend puts a tremendous amount of pressure on growth and resale value that drive management decisions, often at the detriment of building a sound profitable business.
The perception by investors that there is more money to be made on the ups and downs of a stock than on a steady investment is not only flawed as we're seeing today, it's in large part what put us in this mess as it makes for a volatile market.
The problem is hard to fix at a company level though and probably calls for better regulations of transactions. Good luck with that until the next administration at least...
LOVE your blog Hank, but you're just plain wrong about a dividend somehow making it more straightforward to value a company's stock.
Think about it this way: Let's say I make $100k a year, I'll get a raise each year that exactly matches inflation and I'll work for 20 more years and then die exactly after making my last dollar. If you wanted to value me, it's prettys straightforward. I'm worth all my future earnings minus my expenses. Nothing more, nothing less... So if I don't have any expenses and all my earnings go into an account that earns interest matching inflation, my net present value is 2 million dollars. If I divide myself into 10 shares, someone would be smart to by a share for less than $200k and dumb to pay more. This is true whether I give a dividend out of my bank account each year or not (if I give a dividend, there's less at the end but when you put it in a spreadsheet, it still adds up to $2million net present value).
Now, the analogy breaks down a little (only a little though) when you add the fact that companies (in theory) never die, and there is no 'cash-out' at the end... But Net Present Vaule theory teaches us that those cash flows way out there in the future really aren't worth worrying about, so we really don't care if there's ever a 'cash-out' event at some point in the way distant future. And either way, dividends or no, we value the company the same way - we subtract dividends out when calculating net present value.
What markm247 said... Paying or not paying dividends doesn't matter much for determining the value of a company (and so of its shares). That is of course assuming there is a more or less liquid market for the stocks, and assuming the company doesn't cook the books and presents frauduleus statements of expected future developments etc to mislead outsiders.
In a mature company, paying dividends might play a small roll in keeping a company honest (can't pay them if you've secretly run out of cash). But you'll see that dividend paying companies, which often have rather stable payouts, have just as volatile stock prices as otherwise comparable non-dividend paying companies. That is because almost no-one buys stocks for dividends alone, you also hope to sell them later (when you need cash) at a higher price because hopefully the net present value of the company has increased by the investments it has made with the non-paid out profits.
BTW, this disagreement about the role of dividend doesn't mean that I think there is nothing wrong with the stock market and/or the behavior of people playing it :)
When a company pays a dividend, they are essentially saying, "Shareholders can generate more income if they invested this money elsewhere." Companies like Microsoft don't pay dividends when they're growing rapidly because they believe that reinvesting a dollar in the company will generate more income for the shareholder than investing it elsewhere. Only when profit potential stagnates should a company consider paying out regular dividends. But even at that point, it's a risky move because it sets shareholder expectations without knowing the company's future profit-earning potential.
A company like Berkshire Hathaway is a perfect example. BH doesn't pay out dividends (and their shareholders don't want them to) because Buffett and Munger are better at generating income through investments than shareholders are. If BH paid out a dividend, that would be like Buffett throwing up a white flag and telling shareholders that their money is better off invested somewhere else.
Actually Hank, paying dividends is not financially prudent for a company's shareholders. Dividends are taxed as short-term gains, or regular income, and that tax comes immediately. Growth in the value of the stock is taxed as long-term capital gains, a lower rate in the US, and can be deferred (collecting more "interest") until you sell the shares.
Lets say a company had a market cap of 1 million today and generated 100k of revenue in the next year. That company can take that cash and stick it in the bank. The cash still belongs to the shareholders. In a real sense, the company now has a market cap of 1.1 million. If a company has 100k in cash with no debt and a market cap of 50k, then someone will immediately buy them for 50k, close the company, and walk away with the 100k in the bank account. So that cash still contributes to the stock price.
Furthermore, a company can choose to do stock buybacks with their cash which essentially returns the cash to the investors by asking some of them to sell out their shares. This is more tax-advantageous to the shareholders than a dividend but is essentially identical.
I think paying dividends is more than Anonymous 2 msgs ago claims.
Remember that the stockholders have ownership shares in the corporation. When the corporation profits, the owners are supposed to make money. The dividend is a uniform way of paying out profits to the owners.
If the company can make money better than the shareholders can individually, that's great, but if they never pay dividends, the the shareholders will never see that profit themselves. So the officers will get their bonuses and options and all that great stuff, but the investors will get nothing.
Yeah, yeah, I understand the investors can sell at a higher price if the company is worth more, but the old-fashioned point of "investment" is to hold the shares. Without dividends, you don't make money holding the shares until eventually you sell out.
"Without dividends, you don't make money holding the shares until eventually you sell out."
That's not true. If you own at least 100 shares of stock and there is enough demand in the options market, you can write covered calls. In some cases, you can generate far more income writing covered calls each month than waiting for quarterly dividends.
Another point: when a company pays out a dividend, the NAV of the stock should theoretically drop because that money is no longer on the books. It's just a money shuffle.
"The essence of my point is that companies that are not returning profits to shareholders in relatively mature markets are being valued primarily on smoke and mirrors."
No. There's actually quite a bit of science to equity valuation (read Graham and Dodd for more than you ever wanted to know about it). But in a nutshell, an equity's value is largely calculated based on its ability to generate future revenues and, consequently, future profits (revenues less expenses). There's actually a fair amount of science to it - i.e., if a company generated $X million in revenue this quarter, and is projecting $X+10 million in revenue next quarter, and you assume a price/earnings multiple of 18 (e.g., that's in line with its closest competitor), then its stock price ought to be $Y per share.
The trick is that the numbers, of course, are constantly changing - as are both the macro economic environment and the micro economic environment for both the industry as a whole, and for that company specifically. But generally, that's how it works.
So why would someone invest in an equity? Simple: they see something that tells them that the current price of the stock is not accurately reflecting the company's future earning potential, and so they buy it in the hopes of making a profit by selling the stock when it reaches the expected level. (Or, alternately, by selling it short if they think it's going to go down.)
You might argue that this is all complete B.S., since stock prices obviously don't behave quite so rationally. And it's true - in the short term, stock prices can often behave quite *IR*rationally, since on a day-to-day basis stock prices often get distorted based on short-term greed or fear. But over the long term, stock prices actually wind up being very rational, and more often than not wind up exactly where they should based on the financials of the underlying company.
i was going to comment but i just briefly reviewed the comments so far and this whole subject is just plain silly.
Wall Street rarely gives money away, and that's as true of dividends as anything else. For this reason, once the dividend has been announced, the market prices it into the stock. If a company should announce a $1.00 per share quarterly dividend, the market will add that $1.00 into the stock price. For example a $19 stock would usually jump to $20
I came across this page while googling to see if others shared my opinion on this lunacy. I do that on occasion. Hank is sane, which is good to know. :) You might like this page:
http://www.airs.com/ian/essays/stock/stock.html
You'll also like this, the first paragraph in particular:
http://www.financeprofessor.com/financenotes/lessonsoftheweek/DividendPolicy.html
Sadly, most of the commenters who responded here are batshit crazy, and may have irreversible brain damage. :P Per their logic, if we have two companies:
Company A - Earned $1.00 per share this year, growing at 10% a year, never intends to pay a dividend
Company B - Earned $1.00 per share this year, growing at 20% a year, never intends to pay a dividend
Company B is magically worth more because they're racking up earnings faster -- even though they never intend to give a single red cent of those earnings to people who hold their stock? Please.
The goofball who says that Hank is striving for "fixed income" is being glib. There's no reason a company can't grow *and* pay a dividend, much like mighty McDonald's does. That way, the income isn't fixed -- it's growing.
Then there's Greg, who wrongly says that dividends are taxed at normal income rates. Actually, it hasn't been that way since 2003. "Qualified dividends", which include having to hold the stock for 60+ days, are taxed at the lower capital gains rate.
All in all, I favor this form of valuation:
http://www.moneychimp.com/articles/valuation/dividend_discount.htm
Unfortunately, in most circumstances, silly market participants bid up stocks so high that they're all overvalued by that method. The deflationary, fearful environment we're currently in actually has some solid yields and reasonable valuations, but beware value traps whose dividends are due for a reduction or elimination.
To reiterate, I'm amazed by the amount of apparently-educated people who gush over tech companies' "cash flows", even though none of that cash flows into investors' pockets. What the hell good do $50 billion of retained earnings do for me if they're just going to sit on a company's balance sheet, or be used to buy other tech companies?
Buybacks sans dividends are nonsense. So a company has 100 million shares outstanding. They buy back 50 million shares. Now each shareholder owns twice as much of the company as before. But twice as much of WHAT? That shareholder goes from receiving 0 dollars a year -- to receiving 0*2 dollars a year. 2 times zero is still zero, goddamnit.
Unfortunately, like Hank said, if enough people continue to buy into this silliness and chase capital appreciation higher and higher, many of these non-dividend-paying stocks will continue to have goofily high P/E multiples. You would have thought the housing bubble and bust would have taught people a thing or two about endlessly chasing capital appreciation, but alas, not everyone. One commenter on Clusterstock compared the market for non-paying stocks to a game of musical chairs. Pretty apt, I'd say.
Yes, I realize I'm responding to this 4+ months after the fact and nobody will likely read it.. but what the hell, ranting felt good. :P
HEY, I READ THE ARTICLE A WHILE AGO, AND CAME BACK TO IT TO SEE WHAT THE REASON TO INVEST IN STOCKS AT ALL IS. BECAUSE I CAME UPON THIS ARTICLE IN THE FIRST PLACE BECAUSE WHAT MAKES GOOGLE OR ANY OTHER STOCK THAT DOESNT PAY A DIVIDEND SHOOT TO THE MOON. THAT IS WHAT I WAS WONDERING. IT IS ALL A GAME OF WHO WILL BUY WHAT STOCK AND FOR WHAT REASON. SERIOUSLY, IF GOOGLE HAS SAY 200 MILLION OUTSTANDING SHARES, AND THEY PAY NO DIVIDEND. WHY BUY THE STOCK. IT MAKES NO SENSE.
WHAT ARE YOU BUYING. WHEN WILL GOOGLE GO OUT OF BUSINESS AND GIVE US WHAT IS LEFT, NEVER, YOU ARE JUST HOPING THAT OTHER PEOPLE GAMBLE SO TO SPEAK AND PUSH THE PRICE HIGHER SO YOU CAN SELL FOR MORE THAN YOU BOUGHT FOR.
I DON'T KNOW IF GOOG PAYS A DIVIDEND OR NOT, DONT CARE TO LOOK, I JUST WANT TO KNOW WHY PEOPLE BUY STOCKS THAT DONT PAY DIVIDENDS. YOU GET NOTHING OUT OF IT, UNLESS OTHER PEOPLE BUY IT AND THE PRICE GOES UP. AND WHY WOULD PEOPLE BUY, SERIOUSLY, IT MAKES NO SENSE AT ALL.
I AM GLAD YOU POSTED 4 MONTHS LATER ASSASSIN BECAUSE YOU HAD THE BEST ANSWER OF ALL, WELL YOU HAD THE EXACT ANSWER I WAS LOOKING FOR, WHICH IS THAT YOU WILL NEVER EVER EVER EVER GET ANYTHING FOR OWNING A COMPANY THAT DOESNT PAY A DIVIDEND.
Well, you might get something in the form of another investor paying you more for the stock than you had paid somebody else for it. So it's still entirely possible to profit from stocks that don't pay dividends; there's just not much logical underpinnings behind the valuation.
iow, i agree with you about the "game" aspect. :)
Even though this is almost 2 years later, it's still an interesting article.
Remember, as a shareholder, you technically own part of the money that the company is holding on its books. When the company pays a dividend, it becomes less valuable. Your stock represents less money.
Imagine there was a company with no future revenues or costs that simply kept ten million dollars in a bank account that paid no interest. Imagine they sold ten shares. Essentially, you would be buying part of ten million dollars in cash, very indirectly.
Rationally, you'd pay up to one million dollars for one of these ten shares. Remember, as owner of the company, the money on its books is technically your money too.
However, I think you're hitting a much more interesting point: what you really want when you invest is not to lock away your money within a fictitious entity. You want a return not in the economic sense, but in the living sense, you want to buy something else. As Voltaire said, "to make a man rich without making free is a poor joke." Buying this stock might leave you just as rich, but now, because the money is trapped in the company, you are not free to use it as you see fit.
However, because of the liquidity of a public stock market, you can sell to someone else and thus reclaim part of your cash. That's why public stocks are valued differently than private ownership. Private ownership can really only pay out the money that the company can afford to pay and still stay business. Public stocks can account for the whole value of a company.
This form of economic reasoning may be rational, but it may not be reasonable. I'm not sure its really very sane to pay for money you can never realistically use ever, even if exit options are easy, because of the beauty of a market. And such a model of ownership encourages a stock holder to implicitly think in terms of liquidation rather than future profitability. In the longer term, these attitudes are probably dangerous.
Mark
Post a Comment