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MoneyDocSchloss (70.42)

Dividends... AHA!

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February 19, 2008 – Comments (5)

In a previous blog, I noted that with dividends, you don't "get" anything because whatever gets paid to you gets reduced in the price per share.  I.e., if a $100 stock pays a $5 dividend, you're left with $95 in "equities" and $5 in "cash".  The same $100, and thus, getting nothing.

This left me pondering... what's the big deal then??

Luckily, I think I stumbled on the answer inadvertantly while studying for my Series 7. 

And I believe the answer is this...

Dividend Exclusion

"Dividend Exclusion" -->

If a corporation owns less than 20% of another corporation --> it does not have to pay taxes on a whopping 70% of the dividend income it receives.  If the ownership is between 20 and 79%, then it's excluded from 75%; and if the ownership is 80% or above, the exclusion is 100%.

*That was from an online source.  My Series 7 notes say something slightly different.  If it's less than 20%, the exclusion is 70%; more than 20%, the exclusion is 80%. 

But I am certain about the 70% minimum.  So by now the answer is obvious.  Using the example above, a corporation would only have to pay tax on $1.5 of the $5 dividend.  Which could add up to millions of dollars.

The big boys are the real influences on stock prices.  And that my friends, is the big deal with dividends.

Phew!

5 Comments – Post Your Own

#1) On February 19, 2008 at 9:22 PM, DemonDoug (98.85) wrote:

you're forgetting the magic of compounding, my friend.

let's say your $100 stock, you bought it 10 years ago at $50.  Using just the simple example, a $5 dividend would mean that your cost basis is now $45.  Making your 2 bagger a slightly-more-than-2 bagger.  Have to think of overall return as the context, not just the one moment in time payout.

cheers. 

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#2) On February 19, 2008 at 10:44 PM, Imperial1964 (97.87) wrote:

There is open debate as to whether dividends, share buybacks, or business growth is the best, and that depends both on the nature of the company and the situation of the individual investor.  I'll stick to discussing the business-side, which is often overlooked.

You buy stock in a business to get a piece of its future earnings.  These earnings can either be reinvested for growth of the business or paid back to the investor.  Which makes sense?  That, of course, depends on the business.  If the business can invest in growing their business and get better returns than the investor could do investing those earnings on his own, then the company whould reinvest the capital itself.  Growth stocks usually do this.

A more mature company with few opportunities for growth (e.g. Exxon Mobil), should return the earnings to their shareholders, so the shareholders can invest the money elsewhere.  Would you want to buy a company that reinvests earnings at a loss or just hoards cash?

So, the company should either pay dividends or buy back shares.  This choice partially depends on share price.  Also, dividends are considered more stable, as they occur quarterly, whereas buybacks are often prudent when high earnings are not considered sustainable.  Thus many investors prefer the stability of dividends and hard cash in their hands.

For the sake of simplicity, I've ignored paying down debt.  That is another option in order to reduce debt servicing cost and increase future earnings. 

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#3) On February 19, 2008 at 11:18 PM, motleyanimal (97.54) wrote:

Dividends attract income oriented stock funds and retired investors which can help the share price. I favor dividend paying companies these days since I live on that income.

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#4) On February 19, 2008 at 11:51 PM, Bupp (29.32) wrote:

It really depends on where you can get the best return on your capital.  If the company can earn more money for you by reinvesting earnings into the company then you want them to retain the earnings.  If they cannot then you want the company to pay the earnings out in dividends.

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#5) On February 20, 2008 at 12:46 AM, FleaBagger (34.02) wrote:

That's a nice theory, Doc Schloss, but as you should (and probably do) know, in the real world your $100 stock does not have a book value of exactly $100, and there are many things that go into that valuation. If a company keeps retaining earnings and never develops a plan for using them (a la MSFT 2000-02), the cash on their balance sheet is worth less and less to investors, who see no incentive to invest after those dollars if they're just sitting idle on a balance sheet earning 3-5% interest on short term bonds. Investors can get that themselves without the risk of capital loss. A dividend, especially one that has a history of growing and never shrinking, shows that the company is committed to doing something to reward shareholders who remain dedicated owners of the company.

Furthermore, without dividends, the only way to benefit from owning a company is to sell it. Dividends make it more worthwhile to continue owning.

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