Trends in Dividends

During the last ten years, the composition of returns on common stock has changed
significantly, shifting away from dividends toward capital gains. From the end of World War II to 1994, the real return on equities averaged 7.6 percent, with the dividend yield, which averaged 4.1 percent, accounting for approximately three‐fifths of this return (Table 1).

Subsequently, the dividend yield averaged only 1.7 percent, accounting for approximately one‐fifth of the 8.4 percent real return on equity. Before the mid 1990s, equities tended to appreciate at 7.5 percent annually, a rate that essentially matched the average growth rate of companies’ earnings per share and of nominal GDP. Afterward, equities appreciated by 9.3 percent annually, almost twice the growth rates of earnings and GDP. This drop in the dividend yield on equities is mainly due to the substantial increase in stock prices that occurred after the mid 1990s. Before 1995, the prices of stocks in the S&P 500 index averaged about 14 times reported earnings. During the last ten years, this average nearly doubled. This increase in stock prices relative to earnings would have halved the dividend yield, depressing it to 2.1 percent, if companies had held constant the share of their earnings
paid as dividends. Instead, in 2003, dividends’ share of earnings was about a third lower than its prevailing value between 1947 and 1995.


The more rapid appreciation of equity not only depressed the dividend yield, but also
provided shareholders the additional return to compensate for the drop in the dividend yield. Should shareholders continue to expect a total real return of near 7 percent from equities, stock prices would have to continue to appreciate at a rate more than 5 percentage points above the rate of inflation unless dividend yields rise substantially. In other words, at current dividend yields, the rate of growth of real stock prices must exceed that of potential GDP by approximately 2 percentage points.
As was the case in the 1990s, shareholders might expect companies to achieve this
growth by accumulating new assets at a rapid pace, thereby boosting the growth of earnings and dividends in the future. The prospect of substantially greater dividends warrants paying a higher price per dollar of current dividends. Eventually, however, the real growth rate of companies’ domestic assets must approach that of potential GDP; otherwise, diminishing returns will depress their return on assets and their earnings per dollar of equity.1 When the rapid accumulation of assets becomes uneconomical, companies can divert more of their earnings from making new investments to paying dividends. At that time, the composition of the real return on equity will shift once again, moving back toward a lower rate of appreciation and a higher dividend yield.


When opportunities for rapid growth ebb, companies can adopt a strategy that rewards
shareholders with synthetic growth.2 Instead of acquiring new assets, companies can purchase their shares in public markets, thereby increasing their assets, earnings, and dividends per share of stock at rates exceeding the growth of their total assets and earnings. In these cases, the 1 Although expanding abroad can extend the limits to growth, very rapid expansion for very long over a sufficiently wide area can strain the capacity of companies’ managers. 2 Without sufficiently profitable opportunities, companies cannot achieve higher rates of growth simply by retaining earnings to make new investments – lower dividends do not necessarily entail higher growth composition of real returns on corporations’ outstanding equity does not shift so greatly, if it shifts at all, toward a higher dividend yield. Taken to the extreme, companies could cease paying dividends altogether, thereby compensating shareholders entirely through capital gains.


Financial theory has long suggested that corporations should purchase their shares
instead of paying dividends when shareholders’ tax rates on dividends exceed those on capital gains. In these circumstances, the strategy of purchasing shares makes equity more valuable to shareholders and consequently reduces companies’ cost of capital.3 The drop in dividend yields and the generally low dividend payout rates during the 1990s suggest that corporations may have shifted their financial policies away from paying dividends toward purchasing their own shares. Today, three‐quarters of the companies constituting the S&P 500 pay dividends; more than nine tenths did so in 1980.