The Importance of Dividends–Part 2

In an earlier column, I discussed some of our philosophy regarding dividends.  This week, I would like to expand on that somewhat as well as give a quick update regarding taxation of dividends in the President’s budget proposal.

Modern financial theory holds that the value of any investment is the sum of the present value of its future cash flows.  This logic applies whether the investment is a publicly traded stock, a piece of commercial real estate or a hot dog stand.  With a dividend-paying stock, you are getting a return on your initial investment each quarter rather than relying purely on future earnings growth to make a profit. While short-term volatility can be considerable, over longer time periods stock prices follow rising earnings and dividends.

As part of our investment process, we compare the current market price of a stock to its theoretical value using a dividend discount model.  The output indicates whether the company is overvalued (expensive) or undervalued (on sale) based on certain assumptions. All else equal, a company that does not pay a dividend must have a higher expected growth rate than a dividend-paying stock to command the same valuation.  Part of our job is to analyze whether the model’s assumptions regarding dividend growth, the sensitivity of a stock to movements in the overall market, and other factors are reasonable. 

The dividend payout ratio is the proportion of a company’s earnings that are paid out as dividends to shareholders. If a company earned $1.00 per share for a year and paid a $0.40 dividend during that time, the dividend payout ratio would be 40%.  The traditional theory taught in universities and graduate schools all over the world used to be that the lower the dividend payout ratio, the higher the earnings growth rate in subsequent periods.  Recent studies have demonstrated exactly the opposite, that is, that higher dividend payouts actually resulted in higher future earnings growth.  This relationship was shown to hold true across a number of different countries and time periods.  If this theory continues to hold true, it would be a double win for investors, since they would capture both a higher current dividend as well as higher future earnings growth by investing in dividend-paying stocks.  (If you are asking yourself why we don’t invest exclusively in dividend-paying stocks, please see my November 25, 2009 Blog entry). 

Currently, qualified dividends are taxed at the same rate as long-term capital gains, at a maximum rate of 15%.  If the Bush tax cuts currently expire at the end of 2010 as scheduled, dividends would be taxed at higher ordinary income rates for 2011 and beyond. Tax brackets are scheduled to increase, with the top bracket rising back to 39.6% from the current 35% level.  However, President Obama’s budget proposal that was recently submitted to Congress has a maximum 20% tax rate on qualified dividends for single taxpayers earning over $200,000 and couples earning over $250,000.  For those earning less, the qualified dividend tax rate would remain at 15%.  While an increase in taxes on qualified dividends from 15% to 20% is not anyone’s first choice, it is a lot better than going from 15% to 28% or 39.6% as many feared.  It is too early to say whether this portion of the budget proposal will pass, but I believe that the result is unlikely to be significantly worse.

Bill Hansen, CFA

February 26, 2010

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