If you aren’t aware of Matt Yglesias’s work over at Slate, you’re missing out. He’s a phenomenal writer, but great writers may often get in their heads an idea that when put to paper, may not make much sense. I’m not so interested in critiquing one of his recent posts as I am interested in using it to illustrate how the relationship between a shareholder and a company works.

In this article Yglesias makes his case for why dividends are bad. At first, he explains why they are bad for shareholders, but he follows it up by showing how they’re bad for the economy.

Dividends are a way of companies returning profits to shareholders.  A corporation, in principle, exists simply to make money for shareholders.  So it makes sense to give that money back to the shareholders.  You can do this in various ways, but a dividend is one of the most common.  Yglesias argues that when a company pays a dividend, all it is doing is taking an asset on the company’s books and giving it to the shareholder.  And of course the shareholder has to pay a tax on the dividend.  The better option, he says, is to buy back stock.  It has the same effect of returning value to shareholders in the form of higher share prices.  People that want to make money can simply sell the stock and pay taxes that way.

There’s some problems with this view however.  Assume that in fell swoop the company wants to return $10 billion to shareholders.  As a shareholder, I’m technically agnostic to whether it is a buyback or a dividend if the taxes are the same.  I can reinvest the dividend in the company and not pay taxes on it yet.  Or in a share buyback I can simply not sell, see price appreciation, and just pay taxes when I finally do sell.  It doesn’t matter.

There are a couple of major differences between a dividend and share buyback that Yglesias didn’t share. First, buybacks are irregular.  Companies use buybacks when share prices are low and when they want to return excess capital to investors once or twice.  They don’t make as much sense outside of those conditions.  Dividends are used as in income stream.  And since they payments are usually regular and predictable, they make for an important calculation in whether an investor might park their cash with the company.  Second, using a dividend is a means of regularly moving the assets from the company to the shareholder.  In the event of the company facing a lawsuit or financial hardship, the shareholder will have already received some of the company’s assets.  Someone who never sold their shares even during buybacks will be left with nothing in a bankruptcy.  Getting that regular flow of cash is something everyone understands.  Buybacks aren’t so easy to follow.

Now, Yglesias also doesn’t think companies should return capital to shareholders because it hurts the economy.  When a company has an extra dollar, they have to decide whether to invest it in the business or give it back to the shareholders.  The logic is somewhat simple.  Can the shareholder make more with the dollar invested in the company or somewhere else?  Said otherwise, if the company can make an 11% return on that dollar and the shareholder could only make 4% putting it elsewhere, it should stay with the company.  Yglesias says cash-rich companies should invest more in their people and growing the businesses, which helps the economy (it creates new jobs and new consumption).  But this assumes the company always knows what to do with that extra dollar.  In practice, they don’t.  If the company invested the dollar and only got a 3% return, and the shareholder could have gotten 4% elsewhere, the economy loses too.

The oddest assumption of all is that companies exist for the benefit of the economy.  That’s a nice idea, but it’s not how things work.  The a prevailing economic philosophy of our time is that if we all pursue our own interests, the aggregate activity is good for the economy.  This is how the parent company of Yglesias’s own employer acts (which pays a dividend).  And writing a piece like that, was a perfect example of someone pursuing their own interests.

Dividends aren’t perfect by any means.  There’s lots to criticize with corporations these days, and I agree with him that short-term profit views share price pumping often cloud real long term planning and strategy.  But attacking dividends, and calling them “evil”, is a distraction from that conversation.

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categories: investing, media, personal finance