Now, this comes back to the funny question that we discussed previously last period. Almost all the value of the star Inherently is due to the dividends. But firms don't even have to pay dividends, and they often go through years and years without paying dividends. The other thing is, and we have to be clear about this, firms can get money to their shareholders in another way besides paying dividends. You can buy back shares, and firms do that. It's the same thing, and we talked about that, right? You could send a letter with your dividend check and say, "Well, we're really buying back shares." And it wouldn't make any difference, except to the IRS who might decide something different about taxation. But there are other reasons why firms pay dividends. Hersh Shefrin and Meir Statman described what they call a self-control theory of dividend. Now, this sounds funny, but there's a lot of people who invest in stocks and have a personal rule of thumb that I will never dip into principal. The model investor in the stock market in the United States is a 80-year-old woman. I'm exaggerating, not quite 80 years old, a widow. And sometimes they are following the instructions of their late husband, who said never dip into principal, that's for the grandchildren and they never touch it. But then if dividends go to zero, she's in trouble, she doesn't have any income. This sounds really silly, but it actually applies even to such institutions as Yale University, who a half century to a century ago, I think was influenced by the same thinking. So we won dividend paying stocks, and we didn't want to touch the principal. That all changed when we got David Swensen to take over and became a more sophisticated investment manager. Another theory why firms and some of the influences are thinking about dividend, by Bhattacharya, Hakansson and Ross, is that they use dividends to prove to the public that they're really worth something. It's called a signaling theory is a theory that you do something not for its intrinsic value but because it proves something about you. So Michael Spence, who used to be dean at Harvard College surprisingly wrote a famous article saying, college educations are largely signaling. This sounds awfully cynical from the Dean, but he did say that. Why do you go to college? You want to prove two things, you're smart, and you're not mentally ill. Alright, and you can actually slog through all this nonsense that you get in college and you make it up four years later. And so I think there's some truth to this. I hope that's not the only reason you go to college. Why go through all four? Why don't you do a Bill Gates and drop out? You already proved that you could get into Harvard. Why don't you just drop out? Well, you might, if you're an entrepreneur, just drop out because you don't have to prove anything to anyone, but you want to stay the whole four years because that separates you from the people who are unstable, who can't hack the work. So you're proving your work ethic. Well, I'm not saying that's right, that's a signaling theory. Well, it's the same idea that the Bhattacharya, Hakansson and Ross had that firms are signaling. Life is filled with signaling. You're trying to prove one thing or another by doing something. And so firms pay dividends just to show there's real money here. We've really got it. And if we were on the verge of bankruptcy, we wouldn't do this obviously because we would be risking going under. So it's a proof that we're there. We've made it. And I'm sure there is some truth to that. But this kind of signaling does impose taxes. Remember dividends are subject to immediate income taxes, whereas repurchase of shares will not involve any tax until you sell the thing again, sell the shares again. John Lintner was a professor at Harvard Business School, who said that he interviewed a lot of firms about dividends and how they decide. This is unusual for any efficient markets era when he was writing. Usually, he never interview anyone just trust to markets, and so no one can tell you why they do things. But he interviewed three people who set dividend policy for firms and asked them how they did it. And he found that they said all sorts of things. But he said, and the bottom line is, they just gradually adjust dividends toward earnings per share. So they have some target payout ratio. I was assuming above it was one. They were paying out all their earnings, but, in fact, it's less than one typically. And so they change the dividends only slightly each quarter, reflecting an adjustment towards the target dividend price ratio. So you can see that that tau, the target ratio times EPS is the dividends they would have with today's earnings per share. And if it's above their previous dividends, are raised dividends but not enough to put it there. That's because earnings jump around, and the other thing they told Lintner, "We don't like to cut dividends. We never want to cut them. That's embarrassing. People start calling us up and said, "The last quarter you sent me a check for this and this. I need the money. Why are you cutting it?"" And you'd have to tell some story. "Well, our earnings weren't as good as we thought." You don't want to tell a story like that. So when earnings jump up, you don't raise your dividends right away. You just lag behind. And that's what the Lintner model says. Just to give you some idea though, that back in 1968, general public utilities court, which was a utilities company, proposed a substitute stock dividends for cash dividends, and offered to sell the stock dividend to the stockholders for a minimal cost. And we wrote a letter to the shareholders saying this would save them $4 billion a year in taxes. He's saying, "Instead of paying the dividends, we decided to buy back some of your shares. So you now have less shares, but you get the same check, and you're going to get the same check in the future because everybody's shares went down. He explained all this, and they didn't get it. He was just trying to save them on taxes. But you know what happened? He got death threats. Investors are emotional, and somehow, they didn't like the sound of this. It sounded immoral. Cashing in on principle, you're selling our shares. We don't want to sell our share. We just want the money. And it just lost it. People don't think about taxes, even high income people who might own shares, which goes to show why I don't really believe in efficient markets. It's somewhat true, but there's a lot of people out there who don't think very much about investing. And it's such a complicated thing to imagine that the market gets it right. Now, on the other hand, efficient market is still valuable because there is still a lot of smart money. They just don't completely dominate. There is a lot of smart money that will take advantage of mispricing. But they do it at some risk, and it's not a sure thing. And so they hold back a little bit and there are mispricings all over.
