Lower dividend yields today: Lower stock returns tomorrow?

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1 Research note Lower dividend yields today: Lower stock returns tomorrow? Vanguard research May 2011 Authors Karin Peterson LaBarge, Ph.D., CFP Dean J. Hamilton For many years, investors have thought of dividends as a way to value equities and of dividend-paying stocks as part of a welldiversified portfolio. These stocks have been attractive not only for the regular income they provide but also because of their generally lower price variability compared with other stocks. 1 Yet over the past 30 years, dividends whether measured by the number of companies paying them, the dividend payout ratio, or the dividend yield have generally been falling. Many investors have grown concerned about this long-term downtrend and have questioned whether it implies lower equity returns in the future. However, investors need not assume that, because the market s dividend yield is below its historical norm, equities total returns will also be lower in the future. Instead, it s important to consider the ways in which those returns are delivered. This research note discusses the components of total returns for equity investments in the context of dividends, share repurchases, and corporate reinvestment of earnings. How companies transfer value Over the long term, equity investors receive returns in the form of dividend payments, capital appreciation, or both. In addition to dividends, companies also distribute corporate earnings to shareholders through share repurchases. More indirectly, corporations reward shareholders by using cash on hand to pay off outstanding debt 2 or by reinvesting it in productive opportunities to help fuel the growth of the business. Shareholders historically have benefited from this indirect route through higher share prices resulting from increased earnings (see Ibbotson and Chen, 2002). In this paper, we focus on companies direct transfers of value to shareholders in the form of both dividends and share repurchases. We look first at dividends, examining possible reasons for the downtrend in dividend yields. Second, because share repurchases have increased at the same time dividends have declined, we examine whether such buybacks are a substitute for dividends. Finally, we discuss the importance of taking a total-return approach to investing. 1 Baskin (1989) finds that there is an inverse relationship between share-price volatility and dividend yield. 2 Investors can benefit from the retirement of outstanding debt when the cost of financial distress (the risk that creditors will force the company into bankruptcy) would exceed the benefit of the tax shield provided by interest payments (which reduce the base of earnings that are taxable). In this scenario, retiring outstanding debt may reduce the cost of raising new capital in the public markets to fund operations, thus increasing the value of the firm. Connect with Vanguard > vanguard.com

2 Why do corporations pay dividends? Many investors have viewed dividends as an excellent indicator of a company s health because they are a tangible transfer of cash to shareholders. Even though corporations that pay dividends are not legally bound to continue doing so, corporate managers have a tendency to view these payments as a long-term commitment. 3 Some investment professionals look at dividends as a signal of management s optimism about the future, demonstrating the company s ability to reward its shareholders directly rather than applying all its resources to expansion projects. Other investment managers view dividends as a sign that the company no longer has enough attractive investment opportunities and is paying out cash in lieu of capital expansion. Theoretically, equity prices should ultimately reflect the discounted value of the future cash flow that an investor expects to receive over time by virtue of being a company owner. Dividends can provide a substantial fraction of that income. Thus, the ratio of dividend payments to market capitalization the dividend yield has been used by many investors as an equity valuation metric. Because corporate payout policies vary over time and given that many corporations do not pay dividends the earnings yield is another commonly used metric. 4 Figure 1 shows how both measures have fluctuated sometimes dramatically over the decades since Notably, each has trended lower since the early 1980s. For dividends, one likely factor was the adoption in 1982 of SEC Figure 1. Long-term trend in dividend yield S&P 500 Index dividend and earnings yields, % /1928 1/1948 1/1968 1/1988 1/2008 Source: Vanguard calculations using monthly real earnings, dividends, and price data from Robert Shiller (2005; with updates from Shiller s website). Yields are calculated using the average monthly earnings or dividends over the prior year divided by the current month s average closing price. Rule 10b 18, 5 which we discuss later in this paper. Figure 2 provides details of the decline in dividend yields and payout ratios over the three periods shown in Figure 1. We note that the decline in earnings yield may, on its own, raise questions about the direction of future equity returns. But that is a separate issue from the trend in dividend yields, our focus in this research note Dividend yield Postwar period Earnings yield Post-adoption of SEC Rule 10b-18 (November 1982) 0.12 Notes on risk: All investments are subject to risk. Past performance is no guarantee of future returns. Diversification does not ensure a profit or protect against a loss 0.09 in a declining market. There is no guarantee that any particular asset allocation will meet your investment objectives or provide you with a given level of income See Brav et al. (2005) for survey responses given by CFOs and treasurers on corporate payout policies. 4 Low price/earnings ratios the inverse of the earnings yield have historically been correlated with above-average returns (Davis, Aliaga-Díaz, and Ren, 2009). 5 The Securities and Exchange Commission s Rule 10b-18 is a safe-harbor provision that protects companies from liability for market manipulation based on the timing, price, or volume of their common-stock repurchases

3 Figure 2. Dividend metrics decline over time Figure 3. Hypothetical example for share repurchases and dividend payments Sept Aug Average dividend yield 5.6% 4.2% 2.5% Median dividend payout ratio (dividends as % of earnings) 67% 53% 46% Source: Vanguard calculations based on month-end S&P data from Robert Shiller s website ( Per share (20,000 shares Dividend Widgets Inc. outstanding) Market value before dividend $1,500,000 $75.00 Dividend payment 75, Market value after dividend 1,425, Total shareholder wealth $75.00 Share repurchase Many theories on the trend, but no consensus Investors attitude toward dividends began to shift in the 1950s. Benjamin Graham, writing in 1973, stated: In recent years the attitude of investors has been undergoing a gradual but significant change. The basic argument now for small rather than liberal dividends is not that a company needs the money, but rather that it can use it to the shareholders direct and immediate advantage by retaining the funds for profitable expansion.... In the last 20 years the profitable reinvestment theory has been gaining ground. Researchers on corporate dividend policies have explored several avenues but reached no consensus to explain the long-term trend. One area of research asks whether corporate payout policies are related to shareholders individual tax rates on dividends. Some researchers have found a relationship, but others did not. 6 A second approach has investigated the effect of investors attitudes toward dividend-paying stocks. Baker and Wurgler (2004) argued that companies may initiate a dividend when investors place a premium on dividend-paying stocks i.e., bid up their prices. 7 They discovered, however, that the dividend premium has been almost uniformly Market value before repurchase $1,500,000 $ ,000 shares 75,000 $75 for investors who sell, 0 for others Market value after repurchase 1,425, Total shareholder wealth $75.00 Source: Vanguard. negative since the late 1970s, a fact suggesting that managers have had little incentive to initiate a dividend. Share repurchases: A substitute for dividends? Although there is no consensus explanation for the downtrend in dividend yields, the growth of share repurchases by public companies may have played a key role. In theory, investors (as a group) should be indifferent as to whether a company they hold expends $1 in the form of a cash dividend or a share repurchase. Both reduce cash on the balance sheet and directly transfer value to shareholders. Given some simplifying assumptions, as seen in the hypothetical example in Figure 3, a shareholder s total wealth is unaffected by the type of payment made. 8 6 Chetty and Saez (2005) argued that the enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003 induced corporations to either initiate a dividend or increase their dividend payment. Brav et al. (2005) argued that taxes were of second-order importance in the setting of payout policy. 7 Baker and Wurgler (2004) measured the dividend premium by taking the difference in the average market-to-book ratio of paying and nonpaying companies. Of course, this catering theory might help explain the changes in the number of dividend-paying companies, but it would not address the changes in the dividend payout rate. 8 This example assumes that market prices are paid for share repurchases, and it does not account for taxes and other frictional costs. If the company paid a premium for the shares repurchased, the remaining shareholders would be less well off than before; in that case, they would have been better off with a dividend payment. The opposite is true if the company bought its shares at a discount. 3

4 With a dividend payment, all investors receive current income, and the ex-dividend share price falls by the amount of the payment (all else equal). In contrast, a share repurchase provides current income only to those investors who sell their shares, leaving the price of remaining shares unchanged; however, the shareholders who did not sell now have a larger claim on the company s future earnings. With either transaction, the market value of the company afterward is the same. 9 Over the last 30 years, companies have increasingly bought their own stock. The upswing started in 1982 after the SEC adopted Rule 10b-18, which offered safe harbor from the antifraud provisions of the Securities Exchange Act of 1934 to any corporation buying back its own shares. In the early 1980s, the ratio of repurchases to total payouts (dividends and share repurchases) ranged between 5% and 15%; by the late 1990s, repurchases made up nearly 50% of total payouts (Boudoukh et al., 2007). This upward trend continued over the last decade, and prior to the recent recession, managers spent a larger share of their total payout on share repurchases than on dividend payments (see Figure 4). One motive for the increase in repurchases may be managers desire to retain flexibility regarding future payout policy. Unlike dividends, which managers often hesitate to change, share repurchases are not typically viewed as a long-term corporate commitment. Repurchases thus may allow managers to be more responsive to changes in the economic environment. Indeed, in 2008 companies reduced the overall dollars spent on share repurchases by a greater amount than the overall total spent on Dividends versus share repurchases for companies in the S&P 500 Index, Billions ($) Figure 4. $ Share repurchases rose dramatically in the early 2000s 2001 Dividend payments Share repurchases Source: Vanguard calculations using quarterly data from Standard & Poor s dividends (see Figure 4). At the time, many firms cut or eliminated payouts as a way to increase their cash reserves and ride out the recession (Gullapalli, 2009). Critics of share repurchases contend that their rise is related to the increased use of employee stock options (ESOs) in manager compensation. Given that stock prices typically fall by the amount of the dividend (all else equal) and that the exercise price of ESOs is usually fixed without reference to dividends, 10 managers have an incentive to prefer share repurchases over dividends. 9 Although there is no financial difference between a cash dividend and share repurchases, there are practical issues that may affect the market value. For example, if investors believe that the two methods of transferring value convey different messages about the prospects of the business, the market value may change. 10 Murphy (1999) reported that a minority of CEOs have stock options that protect them from the decline in the share price due to dividend payments. 4

5 Should a total-return investor care? It is important that investors consider all forms of corporate payments made to shareholders. Recent research by Boudoukh et al. (2007) proposes a metric to achieve this goal: the net payout yield dividends plus repurchases minus share issuances, all divided by year-end market capitalization. The authors claim that this measure, which incorporates share repurchases as well as issuance, is better at explaining equity returns than the dividend yield alone. (They argue that the predictive ability of dividend yield suffered a structural break around the time of the SEC rule change in 1982.) However, while share repurchases may explain some of the drop in the dividend yield, it is true that the total payments investors receive via buybacks and dividends combined are below their level prior to the end of the Second World War. 11 More corporations 12 are retaining their earnings, which may be used to fuel future earnings growth. Altogether, do these changes mean that investors used to counting on dividends as a significant part of their total return should expect less reward from their stock holdings in the future? There are at least two reasons to question this conclusion. First, investors may benefit more from reinvestment of corporate earnings than from either dividends or share repurchases if corporations use those earnings to fund projects at either (a) a lower total cost of capital or (b) a higher risk-adjusted rate of return than would be possible if the capital were raised externally. Of course, this potential benefit depends on the wisdom of the reinvestment decisions made by corporate managers and the efficiency with which they deploy the retained earnings. Second, taxable investors need to look realistically at their after-tax total return. Prior to 2003, dividends were usually taxed as ordinary income, whereas long-term capital gains have generally been taxed at lower rates. 13 This treatment can make share repurchases a more tax-efficient way for a firm to transfer value to its equity investors. In addition, capital gains are not taxed until the shares are sold, giving investors control over the timing of their tax liability. Conclusion The dividend yield on the broad U.S. stock market has fluctuated significantly over time and is now below its long-term historical level (see Figure 1). Although researchers differ in their explanations for the drop, several possibilities exist. From a corporate finance perspective, there is no difference between dividends and share repurchases as a way of transferring corporate assets to shareholders. However, managements may tend to prefer repurchases. From the investor s standpoint, total return (before tax) should be unaffected by which method is chosen, but there may be reasons for taxable investors to prefer share repurchases. The total-return investor should consider both dividends and capital appreciation: Over the long run, the returns equity investors earn will come both from direct payments and from increases in the value of a productive enterprise. The fact that dividend yields are lower now than in the past does not, on its own, imply that total returns on stocks must be lower going forward. 11 From 1928 through August 31, 1945, the dividend yield averaged approximately 5.6%. From 1998 through 2010, the total payout yield dividends plus share repurchases averaged approximately 3.9%. These figures are based on Vanguard calculations using data from Standard & Poor s and Shiller (2005). 12 See dividend payers data from Standard & Poor s (2011). 13 Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, qualified dividends were taxed at the same rate as long-term capital gains. Congress has extended this provision twice first with the Tax Increase Prevention and Reconciliation Act of 2005 and then with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 and it is currently set to expire at the end of 2012, when dividends will once again be taxed as ordinary income. For further discussion, see Bruno (2010). 5

6 References Baker, Malcolm, and Jeffrey Wurgler, A Catering Theory of Dividends. Journal of Finance 49(3): Baskin, Jonathan, Dividend Policy and the Volatility of Common Stocks. The Journal of Portfolio Management 15(3): Bernstein, Peter L., Against the Gods: The Remarkable Story of Risk. New York: John Wiley & Sons. Boudoukh, Jacob, Roni Michaely, Matthew Richardson, and Michael R. Roberts, On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing. Journal of Finance 52(2): Brav, Alon, John R. Graham, Campbell R. Harvey, and Roni Michaely, Payout policy in the 21st century. Journal of Finance Economics 77(3): Bruno, Maria, No Fun in the Sunset of Tax Provisions: Can You Prepare Your Portfolio? Valley Forge, Pa.: The Vanguard Group. Chetty, Raj, and Emmanuel Saez, Dividend taxes and corporate behavior: Evidence from the 2003 dividend tax cut. Quarterly Journal of Economics 120(3): DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner, Corporate Payout Policy. Foundations and Trends in Finance Vol. 3: No. 2 3, Graham, Benjamin, The Intelligent Investor. New York: HarperCollins. Gullapalli, Diya, Dividend Funds Scramble as Stocks Trim Payouts. Wall Street Journal (March 31): online.wsj.com/article/sb html. Ibbotson, Roger G., and Peng Chen, Stock Market Returns in the Long Run: Participating in the Real Economy. Yale ICF Working Paper No Laise, Eleanor, Dividends are back. Wall Street Journal (June 26): online.wsj.com/article/na_wsj_ PUB:SB html. Murphy, Kevin J., Executive Compensation. Handbook of Labor Economics. Orley Ashenfelter and David Card, eds. Amsterdam: North Holland. Shiller, Robert, Irrational Exuberance. Princeton University Press 2000, Broadway Books 2001, 2nd ed Also yale.edu/~shiller/data.htm. Standard & Poor s, Available at www. standardandpoors.com/indices/market-attributes/ en/us. Davis, Joseph H., Roger Aliaga-Díaz, and Liqian Ren, What Does the Crisis of 2008 Imply for 2009 and Beyond? Valley Forge, Pa.: The Vanguard Group. 6

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