The Investment U E-Letter: #331
Thursday, April 22, 2004

The Truth About Dividends… And 4 Ideas That’ll Surprise You
By Dr. Steve Sjuggerud
President, Investment U

Sam Zell pays you big dividends

As America’s biggest office landlord, Zell paid out $700 million to shareholders of his company, Equity Office Properties, last year – that amounted to a 7% dividend. But should Zell have written $700 million in checks to shareholders? Or would we, as shareholders, have been better off if he had reinvested the earnings in his company (were that an option)?

The real questions are Should we care about dividends? Should we favor companies that pay dividends over those that don’t? Should companies pay dividends at all? And how much should a company pay?

I’ll provide you with some answers to these questions answers to help you better understand – and profit from – dividends. Let’s start out with the traditional wisdom and then finish with my take

Dividends Are the Holy Grail… To Academics, at Least

When I was in college studying finance, we were taught what the professors considered the “Holy Grail” in determining the proper value of a stock. It’s called the “Dividend Discount Model.” It wasn’t until after I graduated and tried to apply it in the real world that I realized the professor’s Holy Grail was actually completely worthless

The basic idea of the professor’s Holy Grail is that the current value of a stock is the value of all its future dividends, discounted back to the present. It’s a nice theory. But it doesn’t work The theory whittles down to this formula: Dividend DIVIDED BY (required return on stock MINUS expected growth rate) EQUALS value.

When you try to apply this formula to a stock like Microsoft a few years ago, you can see where all the problems come in The whole thing amounts to an enormous amount of guesswork – assumptions about growth rates, returns, and when they’ll pay dividends, if ever. With a few bad guesses, you can easily come up with a negative value as the fair value for Microsoft’s shares.

In short, using dividends to value stocks (as they teach in school) seems like a colossal waste of time.

Beyond Theory …Let’s Look Into What’s Really Happening

There are a few theories about dividends that I like. Let’s consider them. There’s

1) The signaling hypothesis… This is the idea that investors don’t necessarily care about dividends in particular, but they do care about changes in a firm’s dividend policy. Investors regard changes in dividends as signals of management’s opinion of the company. If management raises the dividend, it’s optimistic. The stock will react positively. If it cuts its dividend, the firm is in dire straits, and the stock might crater. So the change in dividend is a signal about the company’s prospects.

2) The dividend irrelevance theory… The dividend irrelevance theory is the idea that a company’s dividend policy really has no effect on the value of the company. Instead of calling dividends the Holy Grail, this is the opposite idea

It’s the idea that a shareholder can simply create his own dividend policy if he wants If a person has $100,000 and wants income of $5,000 a year from that portfolio, that person can simply sell $5,000 worth of stock. He doesn’t have to receive it in dividend income. This theory says, “Who cares about dividends?”

3) The bird in the hand theory… This theory says, “I do I care about dividends.” When a company pays me hard cash, I know that the company is really making money. It’s not just telling me it’s making money. In the post-Enron, post-WorldCom world, there’s something to be said for cash in hand. This is the idea that investors value a cash payment in their hands over the hope of future profits.

4) The clientele effect… This is an interesting theory a company tends to attract a set of investors who like its dividend policy. So if a company wants a stable shareholder base, it could have a stable policy of paying out a good percentage of its earnings in dividends. But then the company risks a huge shareholder defection and a serious fall in share price if it cuts its dividend.

What I Think About Dividends

I don’t think that dividends are the right way to value stocks, despite what they teach in school. But I do think the four theories above are all true.

As for me personally, I do like a bird in the hand. Future profits are uncertain. In uncertain times, I like to get paid the cash. The big check hitting your account out of the blue is nice. Whether it’s true or not, it feels less speculative

In sum, I like dividends (particularly if there is no tax effect, like in a retirement account). But ultimately dividends shouldn’t be the primary reason for an investment. The prospects for the potential investment are dramatically more important than the company’s dividend policy.

Only when choosing between two nearly identical opportunities would I choose the one with the substantially higher dividend. That bird in the hand can tip the scales. But don’t let it do much more than that

Today’s IU Cribsheet

• To get more complete information on Sam Zell’s Equity Office Properties, just log onto Yahoo! Finance by visiting http://finance.yahoo.com/q?s=eop

Good investing,

Steve

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• Investing in Dividend StocksThe Truth about Dividends and 4 Ideas That’ll Surprise You