Dividends Are Falling, So Stocks Have Less Value?

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Michael Tsang of Bloomberg recently wrote an article Dividends Falling Means S&P 500 Is Still Expensive indicating that as many companies in the S&P 500 have/will cut their dividends, the index is still over-valued and will likely decline further.

While the market may sell off further, the reason is not because companies have cut dividends. After all, if companies were to announce that they would increase their dividends tomorrow, does it mean the companies will automatically increase in value? If non-dividend companies were to announce they would start to pay a dividend tomorrow, does it mean they are suddenly worth more? Dividends are nothing more than the transfer of funds from companies to their shareholders. The dividend itself has very little to do with the actual value of a company, other than a signaling mechanism we will discuss later. Instead, the value of a company is determined by its underlying operations, which is what allows a company to pay a dividend in the first place. Only by generating more cash than it needs to finance its operating plan, should a company pay a dividend. Thus, for a company like Google with attractive growth opportunities, dividends are basically irrelevant to estimate its value. For mature companies, late in their life-cycle, paying dividends is a way to ensure management does not waste funds on silly projects, or build empires(like corporate jets – hint, hint auto execs). Further, when a company is relatively mature, and it establishes a well-communicated dividend program, it attracts a particular investor base. This puts pressure on a company to maintain and try to increase its dividend payments through time to keep those investors satisfied. Thus a company will only likely reduce its dividends as a last resort, as it understands that the market will correctly interpret that its underlying operations cannot support such payments, and the company’s stock price will drop.

The reason a stock falls when a company reduces its dividend is not because the dividend payment is smaller. Instead, the stock price falls because the market interprets the reduced dividend as a signal that the underlying operations of the company are weaker than previously anticipated, and thus it will generate fewer cash flows. Think this is silly? Think of the following example. Say a company can make its normal dividend payouts, or take its dividends for the year and invest them to purchase the exclusive rights to a proven new technology that will convert garbage to gasoline cheaper than current petroleum based technologies. Do you really think that cutting the dividend in this case will result in the company losing value? If you do, you should stick to investing in bonds.

There are many reasons for the S&P 500 to have fallen over the past two years and continue to fall in value from its current levels, but the cause is not a reduction in dividends. One explanation of the fall of the S&P500 is that the economic profitability of these companies is declining, resulting in fewer expected future cash flows. The chart below shows the weekly forecasted Economic Margins for the S&P 500 over the past decade.

The main take away, is that the industrial companies in the S&P 500 index have exhibited severe declines in their expected economic profitability over the past 18 months. This declining economic profitability, which reflects deterioration in the underlying operations of these companies, is one reason why such firms are rethinking their dividend policies. To believe that the shares of these firms are falling because their dividends are falling is to really confuse correlation and causality.

The value of a firm is determined by its underlying cash flows. Dividends are just one-way via which firms return that value to its owners. Thinking that the value of a firm falls because it cuts its dividend is similar to thinking a car is broken because it is out of gas. While it is true that a car without gas will not run, it does not mean the car is broken. Selling the car thinking it’s broken, will likely lead one to accept a much lower price than what it is worth. Similarly, investors that rely on dividends to understand firm value, will never really understand what a company is worth and ultimately make silly mistakes. 

Related VE Article: EPS Increased.....Company Underperformed?
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1Economic Margin is a metric developed by The Applied Finance Group, Ltd. to measure the true economic profitability of a company after correcting for the numerous distortions found in generally accepted accounting principles. While companies such as World Com and Enron showed accounting profits year after year, AFG’s Economic Margin showed that these companies were destroying shareholder value.
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