Dividends' end
Jan 10th 2002, From The Economist print edition

Should technology companies pay dividends?

RALPH NADER, champion of American consumers, launched himself to fame and riches in the 1960s by exposing flaws in cars' safety. Now the rumpled crusader is fighting a new public enemy: puny dividends. He is scandalised by Microsoft's reluctance to part with any of its $36 billion hoard of cash, which he deems “an inappropriate and...unlawful device”. He calls it a tax dodge and, darkly, “an engine for further monopolisation”. Even some of Microsoft's own shareholders, perhaps fearful that the era of ever-rising stockmarkets is over, are lobbying the software giant to pay out more cash.

Microsoft is not alone in keeping its mattress stuffed. Dividends have long been shrinking; ever fewer companies are bothering with them at all. According to Standard & Poor's, only 72% of companies in its S&P 500 index paid a dividend last year, down from 94% in 1980. Last year, the average dividend payment shrank by 3.3%, the biggest drop in 50 years. Barely one-fifth of all listed American companies paid a dividend in 1999.

Financial theory says none of this should matter. As Merton Miller and Franco Modigliani, two American economists, argued 40 years ago, the level of dividends should have no effect on the value of a share. This “dividend irrelevance” proposition was one of the theories that won the pair a Nobel prize. Shareholders, they observed, hold the same value whether a firm returns cash or retains it. When a firm pays a dividend, the share price ought to fall by the exact amount of the cash: punters are simply being paid with their own money.

Yet dividends, like many things that economists deem irrelevant, do actually seem to matter. This becomes painfully clear when a firm decides to reduce or eliminate its dividend. If the irrelevance theory held in the real world, share prices should not move in response. Yet they typically plunge on this sort of news, perhaps because the change in dividend policy signals trouble at the company. Clearly, punters see a role for dividends that the professors do not.

Other economists have dreamt up theories to explain this role. The first is that investors see a company's promise to pay a dividend as more reliable than any prospect of selling shares to raise cash. A second theory makes dividends akin to a peacock's tail, a signal of a share's value and desirability: only profitable, well-managed companies can afford to pay them. Another idea is that dividends serve as a source of financial discipline, helping to foil expensive mergers or pricey perks for executives.

What about companies that have never paid a dividend? Surely initiating dividends must work wonders for share prices. Actually, no. Steve Milunovich of Merrill Lynch recently looked at three high-technology outfits: Intel, Computer Associates and Compaq. In two of the three, launching a dividend scheme was followed by a decline in price/earnings ratios relative to their competitors.

This result is hardly scientific, but it confirms the intuition of many managers who think that introducing dividends at fast-growing companies might be bad for share prices. To understand why, go back to the signal theory. Just as a dividend might signal stability to some investors, to others it might suggest that the company has run out of good investment ideas. Presumably, that is why dividend-free shares have become the club tie of America's high-growth companies.

Dividends are still an unsolved puzzle for financial economists, eluding any single theory. At the same time, however, managers have devised other ways of returning cash, ones that often better suit a company's (or even shareholders') needs.

Investing in themselves

The long-term decline of the dividend tracks another trend. More companies have been using spare cash to buy back their own shares. This provides a boost to share prices, and means that each remaining share gets a bigger slice of profits.

Buying back shares can be more tax-efficient than dividends, thanks to higher tax rates applied to dividend income than to capital gains in America and in much of the rest of the rich world. Moreover, buy-backs give companies greater flexibility than a schedule of fixed quarterly or half-yearly dividends. They enable companies to return cash to shareholders when investment opportunities flag, or to retain it when profitable projects arise.

In Europe, where dividends have played a bigger role than in America, companies have greatly increased their use of buy-backs in the past decade. CFO Europe, a sister publication of The Economist, found in a study of 127 large European companies that buy-backs have grown from nothing in 1993 to a 15% share of all cash returned to investors in 2000. This growth occurred as the fraction of all profits paid out remained unchanged, suggesting that buy-backs are, as in America, starting to supplant dividends.

The crucial question for shareholders ought to be whether a company has profitable uses for its cash. If it has not, then it is better to return cash to shareholders. The precise method it chooses will always have particular costs and benefits. Some classes of investor will prefer income; others will want capital gains.

Mr Nader is himself no stranger to this trade-off. When he ran as the Green Party candidate for America's presidency in 2000, he revealed that more than a quarter of his $3.8m of net worth consisted of shares in Cisco Systems, another technology company with a huge cash hoard. Shares in Cisco, which has never paid a dividend, have slumped by two-thirds since his campaign. The personal, goes the saying, is political.


  1. Why, do you think, are firms reducing their dividends?
  2. Why did their stock price fall, when Intel, Computer Associates and Compaq introduced a dividend?
  3. What are the different theories explaining dividends?  Provide real-life examples for all of them.
  4. What are the differences between buy-backs and dividends?  Do dividends have an advantage over buy-backs, other than tax advantages?  What about disadvantages?
  5. Is Nader a capitalist?!