Dividends are a real mystery to researchers. In 1976, Fischer Black (yes, the same Black as in Black-Scholes!) wrote a seminal paper looking at corporate dividend payments entitled "the Dividend Puzzle". He concluded:“The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together”. 30 years on, there's still a lot of intense head-scratching going on in the ivory towers. Why all the confusion? Well, while investors are quick to praise the merits of a dividend-paying stock (especially of late!), the thing that stumps academics is that dividend payments should, by their very nature, have a negative expected return. This is for two main reasons...

Why Dividends Baffle The Brains

Firstly, dividend payment tend to lead to double taxation of income - dividends are paid from after-tax profits and yet investors must pay income tax on dividends. That's also at a higher rate than capital gains, in most markets. The issue here is not just the immediate value destruction, but also the lost compounding of those taxes over time. Charlie Munger of Berkshire Hathaway gives an example of a 10% per annum investment that pays taxes every year versus an investment that pays taxes all at the end. Mr. Munger explains:

“you add nearly 2 percent of after-tax return per annum from common stock investments in companies with tiny dividend payout ratios.” 

Secondly, a dividend distribution is essentially just a partial liquidation of the company. If a company has just paid X million in dividends, then its enterprise value has decreased by a corresponding X million. As Modigliani & Miller showed back in the 1960s, regardless of how the firm distributes its income, its value is determined by its basic earning power and its investment decisions. No value has been created by the dividend payment, nada. Indeed, as just mentioned, value is likely to have been destroyed due to the tax effect. As Cameron Hight has written:

"I was sitting beside an economist on a flight to New York City while writing this article and I asked the question, “How much money do you have if a $10 stock pays you $1 dividend?” He said, “$11, the $10 stock plus the $1 in dividend.” In actuality, you still have $10 because the price of stock declines by the…

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