Why would you want a company to pay dividends instead of retaining earnings or buying back shares?

Here are few reasons why one might prefer a stock to pay dividends rather than retain the earnings or use them in a share buyback.

Transaction costs. Supposing that you want to live off your stock investments, your only ways of realizing cash from your stocks are to receive a dividend or to sell some of your holdings. By going the capital-gains route, you may be taxed at a lower rate, but on the other hand you have to pay your broker a commission. Of course this concern has been minimized today but once upon a time commissions were larger and could potentially be very significant (depending on the size of the “withdrawal”).

Transparency. A problem with share buyback is that it is a bit more obscure to the passive, uncritical investor whether it has actually happened or not. Companies declare that they are making $100 million available to buy back their own stock, but then they may not actually spend that much money; or they may buy back some shares, but at the same time the effect may be nullified by shares issued through the employee stock plan. You have to actually check the financial statements to see the number of outstanding shares. In contrast, if a company declared a dividend but then failed to pay the full amount, there would be a big fuss. Nor can a company pay you a dividend, but then surreptitiously suck cash back out of your account to pay to employees.

Irrational pricing.  Suppose you are in a stock market where prices fluctuate irrationally, relative to fundamental value. Suppose also that prices do not substantially affect the fundamental value or the growth of fundamental value; a given company chugs along at about the same rate independent whether the market is treating its stock irrationally well or irrationally cruelly. There are three ways to make money in such a market.

  1. 1.The company can retain earnings and grow in value, and your stock with it. Sometimes the irrational price fluctuations are in your favor, sometimes they are against you, on average they cancel out and your expected rate of return is not affected.

  2. 2.You can try and predict the irrational price fluctuations and benefit from the upward ones while avoiding the downward ones. Of course the irrational price fluctuations may be difficult to predict.

  3. 3.The company can pay out earnings in dividends. Of course if the price is irrationally low, then the yield will be irrationally high, and vice versa.

The attraction of dividends as a mode of investment return in this scenario is that you can benefit from the irrationality without having to predict the fluctuations in advance; you just have to be able to recognize irrationalities that are already present. If there is a company with an irrationally high yield, you can enjoy it without waiting for the irrationality to go away—in fact it doesn't matter if it never goes away!

Comparative tax advantage.  Suppose that, on average, companies are very smart and efficient about setting their dividend rate to maximize AFTER-TAX shareholder return. The rate is set such that the after-tax gain from an incremental increase in the dividend would be exactly cancelled by reduced capital-gain appreciation. Of course, individual companies do not always get the rate right since they are not infallible, but on average, they are smart and get it right.

I have no evidence that such a thing is true, but it seems like the kind of thing that would please an economist if it were true.

In such a world, whose tax rate is used by the companies to determine the optimal trade-off for after-tax return? Obviously, the highest tax rate, the one enjoyed by the large stockholders who influence the behavior of the company.

In such a world, if you are a small fish, then you are best served by seeking out companies with the highest yield possible. Because the yields are optimized for a higher tax bracket, and the dividends are worth more to you than they are to the large investors.

[This argument is partly inspired by a passage in The Intelligent Investor by Ben Graham. Although he did not phrase the argument as I have, Graham liked dividends, and he considered the idea that companies shouldn't pay dividends because they're taxable to be something of a top-tax-bracket fat-cat argument.]