NCPA - National Center for Policy Analysis

Valuing Stocks When Dividends Don't Count

February 13, 2002

Investors during the 19th century and early 20th century had a simple and effective way of evaluating companies: they looked at dividends. But with the dramatic declines of dividends in recent years, there is little concrete evidence of companies' earnings, financial analysts warn. Lack of such a signal is a major reason Enron investors got bilked.

  • Until recent decades, the average dividend yield on stocks was 5.8 percent.
  • But by the bull market peak in March 2000, the average dividend had sunk to 1.2 percent -- although it has since recovered somewhat to 1.6 percent.

What caused dividends to fall out of favor? The answer, some suggest, lies in the U.S. tax laws.

  • Since realized capital gains are now taxed at a maximum 20 percent -- half the top rate of dividends -- shareholders prefer that companies use earnings to lift the price of their shares, rather than pay taxes on dividends.
  • Our tax rules also encourage debt financing -- a trouble spot for Enron and other firms.
  • Moreover, dividends face double taxation -- at both the corporate and individual levels.

Small wonder then that companies and shareholders alike have come to prefer that profits be plowed back into growth strategies -- rather than be paid out in dividends, as was done in the past. Small wonder, also, that investors have such a difficult time uncovering whether their firms' earnings are real until it is too late.

Tax reforms that ceased penalizing dividends, experts argue, would go a long way toward greater earnings transparency.

Source: Jeremy J. Siegel (The Wharton School), "The Dividend Deficit," Wall Street Journal, February 13, 2002.


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