The Dark Side of Dividends
On second thought...

by Ann Coleman
(TMF AnnC)

Alexandria, VA (April 20, 1999) -- The Foolish Four Portfolio gave back some of its gains from last week as the market apparently decided that many of the technology stocks that took such a hit in last week's "flight to value" were now looking like bargains -- some of them (specifically, the ones I own) were bargains lying on the floor bleeding.

Some of the money that came flowing into large cap, traditional companies last week, and that carried our portfolio to a high of $5,175.34, up 27% for the year as of yesterday, flowed back into tech stocks today. The portfolio gave back a little ground -- hey, you guys didn't sell, did you?

We talked about the wonders of dividends yesterday, so today I want to talk about their Dark Side.

Dividends are wonderful, but they carry a high price tag when compared to capital gains. First, if your dividend-paying stocks are not in a tax-advantaged retirement account, you will pay taxes on them at a higher rate than you pay on long-term capital gains. Although the maximum long-term capital gains tax is 20%, (10% if you are in the 15% tax bracket), dividends are taxed as ordinary income, so you would pay a minimum of 15% and a maximum of 39.6% if you are in the highest tax bracket.

This is one of the reasons companies often look for other ways to reward shareholders. One way is to reinvest profits in the business so that it grows at a faster rate, in effect turning those dividends into capital gains. Here's how that works:

Imagine a small company with a profit of one million dollars and with one million shares outstanding. The board of directors has a choice: Reinvest those earnings into new widget-stamping machines and attempt to corner the market on wizziewigs, or pay out the money to shareholders as dividends. Of course, the choice is not all or nothing. Most companies that pay dividends pay out only a percentage of their profits and reinvest the rest. (The percentage of earnings paid out in the form of dividends is called the payout ratio.)

The board of directors has to decide how those profits can be most efficiently used. Small companies that have lots of growth opportunities often find that investing everything in their own business is the most effective use of those profits.

If retaining their earnings and spending them on new machinery (or employees or inventory, etc.) enables the company to increase their earnings by, say, 12% over the next year, which would (theoretically, anyway) increase the value of the business and its share price by 12%, then that would be a wise business decision. That is how dividends can be turned into capital gains.

As a shareholder, which would you rather have: a 5% return on your investment in the form of a very generous dividend, or a capital gain of 12% on which you pay much lower taxes? More money, lower taxes -- more money, lower taxes -- doesn't sound like a toughie to me. Of course, the answer depends on your individual situation and, to some extent, on your opinion of the company's ability to actually produce the expected results, but this is why many shareholders are quite happy for their company to reinvest all earnings rather than paying a portion in dividends.

Another good way for a company to benefit shareholders is to buy back its own stock. This doesn't sound like much at first, but when a company buys back stock, the stock is taken out of circulation. That has concrete and automatic benefits for shareholders.

Say our one million share company decided to use its one million dollar profit to buy back its stock on the open market. The company is selling for $20.00 per share. (Attention, Class -- that makes this company's P/E what?)

Now, suppose the company spends its million bucks to buy 50,000 shares. That's 5% of the company taken off the table. The effect is very interesting. With those shares taken out of circulation, the earnings are spread over a smaller number of shares outstanding. All other things being equal, this will automatically drive up the price. How? The P/E.

Buying back stock doesn't increase the company's ability to generate earnings. But it increases earnings nonetheless because those earnings will be shared among fewer owners. If the market is valuing a company at a P/E of, say, 20, and the E part of the equation (earnings per share, remember) goes up, then so does P.

Here's how it works: Suppose the company makes no progress in growing earnings over the next year at all (not surprising since we left it no cash to grow with!). Come the end of the next year, the company makes another million bucks of profit, but this time those bucks are spread over only 950,000 shares. That means earnings per share will be $1.05. A five percent increase in EPS -- when the company earned exactly the same amount of profit. If the company is still selling for the same P/E at that point, then the price of the company will now be $21, a five percent increase. 21/1.05 = 20.

Someone who bought the stock at $20.00 and sold a year and a day later at $21.00 would realize a long-term capital gain of 5%. Depending on your tax bracket and state capital gains rates, the shareholder is 6% to 32% ahead on this deal compared with a 5% dividend.

Hummm. Maybe instead of a rousing Hurrah, a smattering of polite applause for dividends would be more appropriate.

Fool on and prosper!

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Today's Stock Lists | 1999 Dow Returns

04/20/99 Close
Stock  Change   Last
CAT  -1  1/16  60.69
JPM  +2        138.63
MMM  -2  5/8   81.63
IP   -2        53.75

                Day   Month    Year   History
       FOOL-4   -1.71%  21.85%  25.31%  27.18%
        DJIA     +0.08%   6.77%  14.19%  13.73%
        S&P 500  +1.29%   1.54%   6.58%   6.84%
        NASDAQ   +2.73%  -2.12%   9.89%  11.40%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     60.69    40.87%
 12/24/98    9 JP Morgan    105.51    138.63    31.39%
 12/24/98   22 Int'l Paper   43.55     53.75    23.42%
 12/24/98   14 3M            73.57     81.63    10.95%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1456.50   $422.50
 12/24/98    9 JP Morgan    949.62   1247.63   $298.01
 12/24/98   22 Int'l Paper  958.12   1182.50   $224.38
 12/24/98   14 3M          1030.00   1142.75   $112.75

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5087.09