by Archie M. Richards, Jr., CFP^®
September 10, 2001

Here's the skinny about dividends.

Let's say you're a shareholder of a publicly held company that cleans homes and offices. The year's revenues are $100 million. Wages and salaries are $80 million. Vacuum cleaners, rags, uniforms, trucks, and gas cost $10 million. Corporate income taxes come to $3 million. The net, after-tax earnings for the year - drumroll, please - are $7 million ($100 - $80 - $10 - $3).

The company has 10 million shares of stock outstanding, including those owned by employees, institutions, and individual investors. With net, after-tax earnings of $7 million, the earnings per share (EPS) are $.70 ($7 million earnings divided by 10 million shares).

The Board of Directors decides to pay dividends of $3 million for the year. (Actually, Boards make such decisions quarterly.) With $7 million net earnings, less the $3 million paid in dividends, $4 million remains. The company buys more vacuum cleaners, rags, uniforms, trucks, and gas to stimulate further growth.

Not all companies pay dividends, of course. High-technology products become obsolescent so quickly that most high-tech companies must spend every nickel to keep up. The entire return to shareholders depends on the stock price appreciation. (The darn things don't always comply.)

On a per-share basis, the dividends come to $.30 ($3 million of dividends divided by 10 million shares outstanding). Let's say the price is $14 a share. The dividend yield is the annual dividend per share ($.30) divided by the current price per share ($14), making the yield 2.1 percent. We're talking high finance, kiddo.

Although the dividends may change quarterly, the prices of many stocks fluctuate from second to second. If the company's price rises from $14 to $16, which it could do by the morning coffee, the dividend yield drops from 2.1 percent to 1.9 percent (the annualized dividend of $.30 a share divided by the new price of $16). Shareholders don't mind the yield declining, because the price rise increases the holding's value. But then again, the dividend is cash-in-hand, while the price could drop back to $14 by teatime.

Corporations can't deduct dividends. The earnings are taxed before the dividends are paid. The dividends are also taxed to shareholders, at high rates, too, as if they were received in salary. Dividends are taxed twice.

Corporations therefore minimize dividends and acquire more deductible goodies, like vacuum cleaners, trucks, and factories, that stimulate earnings growth and make stock prices rise faster. There are tax savings on that score.

Shareholders can save taxes too, by buying stocks that don't pay dividends and holding for at least a year. When the stocks are sold, the long-term capital gains are capped at only 20 percent tax. If you hold for at least five years, the gains are taxed at only 18 percent. But the substitution of dividends for capital gains increases risk. Dividends are today, while higher stock prices and capital gains are tomorrow.

With dividends taxed to both the corporation and the shareholder, companies borrow more than they otherwise would, because interest is deductible while dividends are not. Debt makes profits higher when things are good and lower when things are bad. Stock prices therefore fluctuate more than they otherwise would. Many investors avoid stocks because of the excessive volatility.

The avoidance of stocks very likely suppresses the stock offerings of fledgling corporations. Small corporations are the nation's principal source of new employment. The double-taxation of dividends probably reduces employment and does more harm than good.

The further stock prices fall, the more that investment professionals turn bearish. Don't get sucked in. Prices could begin going up any time and continue rising for decades.

Remember President Reagan's message: "Government is not the solution; it's the problem"? Well, President Bush wants the Department of Education to impose testing standards on local schools. Instead of making schools accountable to local governments and parents, his proposals make them accountable to the feds. Wrong direction. Bush acts as if government isn't the problem; it's the solution.

American education instead needs private ownership and entrepreneurialism. Government control works no better for education than it does everywhere else. No wonder so many people can't read.