OK, I've had enough.
It seems as if every day a pundit claims that Apple (Nasdaq: AAPL) and Google are hurting shareholders by not paying a dividend, or that Microsoft (Nasdaq: MSFT) and Cisco (Nasdaq: CSCO) aren't paying enough.
I've beaten around the bush on this issue before, but it's time for me to explain -- in no uncertain terms -- why this is not so.
The dividend illusion
Let's say Tim Cook listened to the pundits and paid a dividend of $10 per share. What would happen to the share price of Apple, all else being equal, when the stock went ex-dividend?
The share price would fall $10.
So let's see -- you've received $10 in dividends and your share price fell by $10. On the whole -- not taking into account the double taxation of dividends -- you're back where you started. No more, no less.
Now, I'm sure some of you are skeptical that Apple's share price would really fall by $10. But think about what that would mean if it didn't: You could buy the stock just before the ex-dividend date, sell it ex-dividend, and pocket the dividend with no risk. You'd be getting something for nothing.
If this worked, everyone would do it. And there's no reason why it should: As a shareholder, it's your cash regardless of whether it's given to you in higher shareholders' equity per share (which increases the share price $1 for $1) or a cash dividend. You can always sell shares to create a dividend in whatever amount you wish. As long as management isn't lighting cash on fire (literally or metaphorically), you're free to access it either way.
How I learned to stop worrying and love the cash hoard
The fact that stock prices fall ex-dividend is predicted by a watershed, and extremely counter-intuitive, theory in finance that has tremendous implications for our cash hoarders.
In 1985, Franco Modigliani was awarded the Nobel Prize in economics for what is now commonly known as the Modigliani-Miller capital structure irrelevance theorem. Try whipping that out on a first date … preferably with someone you don't care to marry.
The easiest way to explain it (for the three of you still listening) is with homebuying. It's a bit of a simplification, but it will do for our purposes.
Say you want to buy a house. You have three financing options:
- Equity financing: Pay in cash like grandpa did. The downside is that it's your money at risk, not the bank's, and appreciation in your home price isn't guaranteed. Therefore, you're going to require a high return on it to compensate for risk, making it costly.
- Debt financing: Mortgage debt is usually pretty cheap, because the bank is contractually guaranteed a return or it gets the house.
- Some combination of the two.
What's the least costly way to finance the house? In fancy-pants finance language, that's asking which way minimizes the house's weighted average cost of capital, or WACC.
According to Modigliani and Miller, there's no wrong answer in a perfect and efficient capital market (we'll get to that). Your choice is irrelevant.
The more cheap debt you use, the more at risk you'll be of defaulting, and therefore you'll require a higher return on whatever little equity you have. Conversely, the more "costly" equity you use, the less chance you'll have of losing it in a default, and therefore you'll require a lower return on said equity.
The end result is that the house's cost of capital is the same no matter how you finance it. Any advantage in using more debt gets nullified by a rising cost of equity.
Therefore, you should focus on getting the right house at the right price -- making a good investment, in other words -- and not the financing.
And that's the essence of Modigliani-Miller: What creates or destroys value is investment decisions (like iPad development), and not how those decisions are financed.
So what does this have to do with dividends or tech-company cash hoards? Letting the cash "hoard" grow pushes a capital structure toward equity. (In Apple's case, it's even less of a non-event since it's already 100% equity.) According to M&M, there is no harm in this as long as the cash is invested in something with returns commensurate with the risk. And since tech-company cash is basically sitting in T-bills, this is the case.
Now, I agree that in the real world, companies look at taxes, transaction costs, and other factors as they come up with an optimal capital structure. Such tweaking may allow a company to benefit from such frictions. But you certainly won't be able to retire on it.
And that's the basic lesson of Modigliani-Miller for investors: What's going to create or destroy value over the long run is how well a company invests, and not its capital structure or dividend policy. A bad company can't save itself by messing with capital structure or dividends, and poor dividends won't sink a good company. At the end of the day, it's about wise investing, baby. Just look at the success of dividend-less Berkshire Hathaway (NYSE: BRK-B).
Therefore, Apple should be applauded, and not shunned, for neglecting dividends and keeping a apathetic capital structure (100% equity). In a decade when so many corporations tried to create value through financial wizardry, Apple kept its eye on what matters most: investing in profitable ventures like the iPhone, iPad, and iPod.
Why dividend stocks outperform
Some of you might be saying, "Well, won't having tons of cash make it easier for a company to waste my money? Just look at Microsoft buying Skype. Or Microsoft bidding on Yahoo! Or anything Microsoft has done in the past 10 years. What about buying back shares at wild valuations?"
Sure, but if you don't trust a company's management, why would you own the stock in the first place? You have no business partnering with a management that you think wastes your money, dividend or no dividend.
Besides, managements don't need cash to steal from you. They can waste money issuing stock or debt: look at Kraft's Cadbury acquisition. If capital allocation is the problem, the solution is changing the regime and culture of the organization -- not dividend policy as a prophylactic.
As for why dividend payers beat the Dow Jones Industrial Average (INDEX: ^DJI), as Jeremy Siegel and other dividend pushers attest, remember that correlation is not causation. I'd wager that once again it's investment policy -- and not the dividend policy itself -- that causes dividend-paying stocks to outperform. Having the surplus free cash flow to pay dividends is often the sign of a company that makes wise investment choices. That's why Vanguard Dividend Appreciation (NYSE: VIG) is my largest holding.
So the bottom line is that if you're comfortable with how Apple, Google, Cisco, and Microsoft invest money, and you believe in their managements, and think their valuations are reasonable, don't let the pundits scare you with dividend policy.
Though with double taxation, if I were Tim Cook, I’d stick with no dividend.
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