Dividends
Dividends are payments that firms make to their shareholders. Historically dividends
were a major portion of returns to stockholders. Since the late 1980s dividends are
taken a back seat to capital gains, but dividends are still an important part of any
stock.
There are several types of dividends. Generally dividends are cash payments, but as
we see with stock dividends it is not always the case.
Type of dividends
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Ordinary (or regular) dividends-Regular dividends are paid in cash at regular
intervals. Most firms pay these out quarterly, but there are firms that pay at
other intervals (monthly or annually).
Special (or extra) Dividends-A one-time dividend that is not expected to be
reoccurring.
Stock Dividends-Stock dividends are really mini-stock splits. The company
gives new shares to existing shareholders.
Other types of dividends-
Dividend Policy
The company’s Board of Directors makes dividend decisions. They are faced with
the decision to pay out dividends or to reinvest the cash into new projects.
In a perfect world dividend policy would not matter since the return that investors
would earn would be the same as the return that the firm would receive if the cash
were reinvested. (This is the idea behind Nobel Prize winners Modigliani and Miller's
work in the field).
However, the real world is not perfect. There are taxes, information asymmetries, and
conflicts of interest. In this world dividend policy may matter. For example, if you
think managers will waste any cash they have, you would prefer larger dividends even
though your taxes will rise.
How does the Board of Directors decide how much to pay out?
The classic work in this area is by Lintner (1956). He found that managers
hate to cut dividends (because investors see cuts as a signal that things are
going poorly). Thus once the Board of Directors decides to raise dividends
they want to be sure they do not need to cut them in the future. This leads to
"sticky dividends." Sticky dividends refer to the idea that dividends track
earnings but with a lag since management wants to be sure the earnings are
sustainable.
Key Dividend Dates
Announcement date (Declaration date)-this is the date that the board of directors
announces that a dividend will be paid. If the dividend is good news, this is the date
that the stock price will rise on.
Shareholder of Record date- this is the day that the firms decide who gets paid a
dividend. You can imagine a firm opening up "their books" and seeing who owns
stock. Whoever is listed will get paid. Remember however that it takes a few days to
be listed. Thus, you may own stock on the Record date and still not get a dividend.
Cum Dividend date-This is the last day that you can buy the stock and still get the
dividend. (In other words if you buy today the firm still has time to get you listed on
their books by the Record date.)
Ex-dividend date-This is the first day that you can buy and NOT get the dividend. (In
other words you are too close to the Record date for the firm to record your owning
the shares.) On this day the price of the stock will open down by the amount of the
dividend. Why? The day before the stock was worth more because those who bought
it would get a dividend, now the dividend is not included.
Payment date- This is the day that the firm actually pays the dividend.
Dividends and Taxes
Dividends are paid out of earnings. These earnings were already taxed. When a
dividend is received, the investor must pay taxes on the dividend. This dividend is
generally taxed as ordinary income. This double taxation is a big problem when
paying dividends.
In many nations the Stock Buybacks can be used as an alternative to dividends. The
rationale behind this is that the investor need not sell. Thus, investors can "time" their
taxes. Further, in many nations capital gains are taxed at a lower rate than is ordinary
(dividend) income. However, if a firm uses stock buybacks exclusively to avoid
taxes, the IRS will intervene and disallow the lower tax.
An additional point is worth noting: corporations that receive dividends can exempt
70% of the dividend for tax purposes. This is aimed at preventing triple taxation.
Because of the advantage of timing the tax as well as the lower capital gains tax rate,
most people believe there is a disadvantage to paying out large dividends. This view
has really caught on in recent years as firms have not raised dividends but rather
reinvested and/or done stock buybacks.
Stock Buybacks
Stock buybacks have grown in importance since the mid 1980s. Find out why!
What is a stock Buyback?
As its name suggests a stock buyback is when the firm buys back its own shares.
Why buybacks are popular
Buybacks have several advantages over dividends.
1. Taxes: Probably the biggest reason why stock buyback plans have become
more important is taxes. When a company pays a dividend, all shareholders
must pay taxes on the dividend. When a company makes a stock repurchase
shareholders have the option of selling. They can thus choose to avoid paying
taxes. Further, in many countries (including the US where buybacks are most
popular) capital gains are taxed at a rate lower than ordinary income whereas
dividends are taxed as ordinary income.
2. Signaling: Managers can signal their belief that the stock is undervalued, by
buying it. (As an historical note, the importance of this can be seen after the
crash of 1987 when most large firms announced buybacks and this was
credited by many in helping the market to bounce back.)
3. Flexibility: Dividends are hard to cut. Stock buybacks offer the management
more flexibility in the size and timing of the trades.
4. Stock Option plans An often-overlooked reason for many buybacks is to fund
employee stock ownership plans. The firm buys back shares to give to its
employees.
Type of Buybacks
1. Open market repurchases- here the firm buys its shares back in the open
market. That is they "call" a broker and purchase shares in the same manner
any ordinary investor would. This takes some time but is fairly easy and is
usually used for relatively small repurchases.
2. Self-Tender offers-this is usually used for larger buybacks. The firm
announces that they will pay a set amount for each share (often up to a limit)
that is tendered (given) to the firm. (A variant of this is a Dutch-Auction Self
tender where the firm asks the shareholders at what price they would be
willing to sell at.)
3. Greenmail-this is a targeted repurchase and is usually used to get rid of
onerous shareholders. Many shareholders do not like this as the buyback is
often done at a premium and the shareholders that are not allowed to
participate lose out. (Often used as a takeover defense.)
Market Reaction to Buybacks
Comment and Jarrell (1991) report that firms experience a 2% abnormal positive
return on the announcement of a stock repurchase plan.