Enough about the “Fiscal Cliff”

Posted on Posted in Financial Blog

With progress on averting the fiscal cliff running at the usual glacial pace of political deal making, few things are certain about next year’s tax rates. Among the likeliest of changes, however, is an increase in the rate on dividends and capital gains. The best guess is they will increase to 20% from the current 15%, with a 3.8% Medicare surcharge for high earners. The actions of a number of large public companies (and even quite a few small private ones) suggest that they expect dividend rates to rise in 2013, and they are taking actions to allow their shareholders to benefit from current historically low tax rates.

Special dividends ahead of potential tax increases

In recent weeks, a number of companies, including Costco (NASDAQ: COST), Las Vegas Sands (NYSE: LVS), Disney (NYSE: DIS) and Oracle (NASDAQ: ORCL) have announced “special dividends” (special because the amounts are greater than the companies’ typical quarterly dividends) that will be paid out before the end of this year. On the one hand, this indicates that corporate executives believe dividend taxes will increase in 2013, and companies want to distribute cash while tax rates are still at historic lows. But what you won’t hear in the news is that a single large dividend payment can also be a sign of the strength of these firms’ balance sheets and their confidence in the future. Keep in mind that a high dividend amount or a high dividend yield, defined below, is not necessarily a positive indicator.

A dividend is a distribution to a company’s shareholders, usually in the form of cash. Regular cash dividends are typically paid by firms that have a comfortable capital cushion and predictable cash flow: you won’t find startups or young biotech firms paying dividends, as they need all the money they can get their hands on for R&D and growth. Companies like Apple and Microsoft, however, believe they have sufficient resources to pay for both their current operations and future projects, plus a cushion for extraordinary events such as lawsuits. Thus if Costco, Sands, Disney, Oracle and everyone else paying out special dividends couldn’t easily afford them, they wouldn’t be distributing cash to their shareholders.

Note that executives often hold significant amounts of their company’s stock. This doesn’t mean they would be incentivized to pay out cash the company couldn’t truly afford; it just means that when management issues a dividend it is not a totally “selfless” act. Sheldon Adelson, chairman and CEO of Las Vegas Sands, and his immediate family own roughly 194.6 million of the company’s 821.5 million outstanding shares (23.7% of the company). As a common shareholder, he will receive the same $2.75 dividend payment per share as every other investor, which will net him $535.15 million before taxes. (He may need the money after spending about $100 million on mostly failed Republican candidates in the recent election.)

The following is not crucial to understanding the significance of special dividends, but it will provide a more complete understanding of dividends in general.

Why dividend yield, not the amount of the dividend, is important

The size of a dividend is determined by the dividend yield, not the dollar amount of the distribution per share, and is calculated using the following formula: Dividend Yield = Annual dividend per share / Stock price per share.

Apple (NASDAQ: AAPL) is on track to distribute $10.60/share in cash dividends over the next year, while BP plc (NYSE: BP) only plans to pay out $1.98/share in dividends. However, Apple’s dividend yield is 1.8% compared to BP’s 4.8%, because Apple’s share price is so much higher. If you own $100,000 worth of both stocks you can expect roughly $4,800 in BP dividends and $1,800 in Apple dividends annually.

While this example shows why the dividend yield is more important than the dividend amount, it is also an excellent example of why a high dividend yield isn’t always a good thing. Given BP’s fundamentals, its stock should be trading at least $10/share higher, but owing to the aftermath of the tragic Deepwater Horizon oil rig explosion and spill in 2010, investors are cautious about the company’s future. If its stock price were higher, and the company in a better place, its dividend yield would be significantly lower.