Much has been made of Apple Inc. (AAPL)’s recent decision to begin paying regular dividends, given the company’s large free cash flow (about $1 billion a week) and cash balance (close to $100 billion).
Yet, according to finance theory, stock-market investors should be indifferent to whether they receive their returns as cash dividends or capital gains. In fact, when dividends are tax disadvantaged, as was the case until 2003 and may be so again soon, investors should prefer retention and the resulting capital gains. This led economists — notably Fischer Black in 1976 — to describe the payment of dividends as a puzzle.
If dividends were puzzling in 1976, they are even more so today because companies can now return cash to stockholders using stock repurchases, which have at least two advantages over dividends.
First, stock repurchases don’t commit companies to future distributions. By announcing a dividend, however, managers are essentially committing their firms to paying a regular dividend for the foreseeable future.
Second, if President Barack Obama has his way and dividends are returned to their traditional tax-disadvantaged status, the case in favor of stock repurchases becomes even stronger.
STOCK REPURCHASES: For a while, it did seem that dividends were in retreat and that stock repurchases would become the dominant form of payout. The use of stock repurchases has grown tremendously since their emergence in the early 1980s. It is no longer uncommon for there to be years when the dollar amount of repurchases exceeds that of dividends, something that first occurred in the late 1990s.
Meanwhile, dividends seemed to be disappearing. In a paper published in 2001, the economistsEugene Fama and Kenneth French reported that just one-fifth of U.S. nonfinancial firms paid dividends in 1999, compared with two-thirds in the mid-1970s.
Further, survey evidence suggested that the only reason managers of the remaining dividend payers continued that practice was because their companies had done so for many decades.Coca-Cola (KO) Co., for instance, has paid dividends each year since 1920, making it a difficult habit for its investors (and managers) to break.
In recent research, we used data on companies’ payout policies through the financial crisis to shed new light on the dividend puzzle. The idea was simple: If dividends are an inferior payout vehicle, it was reasonable to expect that managers of companies wishing to end them could use the Great Recession as a convenient excuse. Given the upheaval in the financial markets in 2008 and 2009, along with the related economic downturn, investors would surely understand the need to dispense with dividends.
We found little evidence that nonfinancial firms cut dividends during the crisis. While many banks and other financial firms cut back their payouts, many of them only did so when forced by regulators. Remarkably, even banks receiving taxpayer money from the Troubled Asset Relief Program continued to pay dividends, though the government soon forced them to stop. This fact alone is testament to the staying power of dividends.
For many dividend payers it was business as usual during the crisis: Blue-chip companies such as McDonald’s Corp. (MCD), Procter & Gamble Co. (PG), Coca-Cola, PepsiCo Inc. (PEP) andExxon Mobil Corp. (XOM) continued to increase their payouts, as they had for many decades.
CONCENTRATION OF COMPANIES: We also found that the share of dividend payers bottomed out at 15 percent in 2002, and has increased since then. Further, as discussed in a 2004 paper I wrote with Harry and Linda DeAngelo, there has been a strong increase in the concentration of dividend payments over the last 30 years: While the number of firms paying dividends has declined steadily, the total amount of dividends paid has risen (in real terms, adjusting for inflation). The paper reported that the top 25 dividend-payers accounted for more than half of all dividend payments by public nonfinancial firms in 2000.
Also inconsistent with the idea that repurchases are a substitute for dividends is the fact firms that pay the largest dividends also tend to be the largest repurchasers. Instead of cutting dividends to make repurchases, the small set of large blue-chip industrial firms that pay dividends have augmented their payouts with repurchases. Because repurchases are so flexible, these companies can use them to pay out excess earnings in unusually good years, so payout ratios for these firms (the ratio of payouts to earnings) are often well above 50 percent.
In our recent paper, we find that the growth of total payouts — dividends and repurchases — has been very strong over the past decade. From 2001 through 2007, aggregate dividends paid by nonfinancial firms almost doubled while repurchases for these firms increased by a factor of five. Strikingly, aggregate payout ratios increased to about 80 percent in 2006 and 90 percent in 2007, before the crisis caused companies to radically reduce repurchases.
Is it good for the largest companies, those that contribute the lion’s share of earnings, to be distributing so much cash? If firms are distributing the bulk of their earnings to stockholders, it means that they aren’t investing in the equipment or undertaking the research that leads to future improvements in productivity, earnings and job creation.
But back to the original question. It seems clear from our recent work that dividends are very resilient, and are unlikely to disappear. What explains this staying power?
First, some argue that dividends provide important “signals” about the strength or quality of the firm’s underlying earnings stream. (Because investors know that a significant dividend is a very strong commitment to paying out at least the current dividend amount on a continuing basis.)
Second, dividends help discipline managers’ tendency to squander their firms’ cash on wasteful or unproductive projects or acquisitions. This is particularly a problem in large, mature companies that generate sizable free cash flow.
Third, it could be that companies are catering to certain investors, who have a strong preference for dividends over capital gains. This not only applies to the traditional “widows and orphans” who might discipline their spending by limiting consumption to dividend income, but also to large institutions such as pension funds that often face institutional and regulatory restrictions forcing them to invest only in dividend- paying stocks.
Although we haven’t yet established the reason, the data are very clear: Dividends, even though they remain a puzzle, are here to stay.