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Should dividends be outlawed?
Take for example the perverse scenario in General Electric in twenty seventeen. Management cut the dividend by half. The stock dropped by eleven percent that day.
Did this shock shareholders? I doubt it.
The company had been bleeding cash.
The firm continued to pay dividends regardless. The share price had already dropped from thirty to twenty dollars.
Bad management lacked the courage to do the right thing.
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The takeaway is that there is a strong rational for well managed firms to not pay coffer draining dividends. And many stocks today do not pay dividends.
This fact pokes a stick in the machinery of dividend yield investors. Beating the Dow is a classic read by Wall Street practitioner Michael O’Higgins. Another is Stocks for the Long Run by Jeremey Seigel, a finance professor at Wharton.
Both books show that investors can get a few percentage points in return over the indexes buying stocks that pay lots of dividends relative to the stock price. But watch out!
Recent evidence by financial economists indicates that the dividend yield premium has been arbitraged out of the market. The take way is that this strategy may well be a waste of time today because of market efficiency.
Yale School of Management finance professor by day and Nobel Laureate by night Bob Shiller pointed out that common stock was a hard sell to bond investors back in sixteen hundred. So, the Dutch East India Company started paying an eighteen percent regular dividend to draw capital away from bonds.
Common stock unlike interest bearing bonds offers no guarantee of payment.
University of Toronto finance professor Myron Gordon developed an equation of how dividends impact common stock value. This simple equation I am looking at now is enormously useful for developing a sound economic intuition regarding how dividends impact the value of the stocks you invest in.
In the simplest scenario dividend growth is constant. The discount rate is greater than the dividend growth rate.
The equation teaches us that the value of common stock today is simply the upcoming dividend divided by the discount rate less the dividend growth rate. Most MBA students grasp this easily.
But both professor Crack and I have noticed that they have difficulty understanding that the theoretical stock price grows at the dividend growth rate. And that the required stock return is a combination of both the capital gains rate and the dividend yield.
Also, something subtler is that the dividend yield has to be constant if dividends and the stock grow at a constant rate. Strange values pop out of the model when the difference between the discount and dividend growth rate is very small.
Another useful aspect of the Gordon-Shapiro model is that it can be rearranged to calculate the dividend growth rate. This is helpful when you know stock prices and dividend amounts as well as the discount rate.
Finally, the model can be expanded for multiple dividend growth rates. What is the takeaway from all of this?
The Gordon-Shapiro model is commonly used to generate expected future prices of stocks. If you understand the model and the intuition you can decide for yourself if you agree with Wall Street Analyst stock forecasts.
Furthermore, and way beyond into option theory. Here is one subtle point.
When a company pays a dividend, the earnings drop a little.
Call prices drop a little too. I will explain in detail why in a podcast episode down the road when we talk about option theory.
If you want to dig into actionable material right now, go over to Rhodes Society dot org and get on our e-mailing list.
Then go to Amazon to pick up Beating the Dow and Stocks for the Long Run. Two killer reads, I assure you!