Few examples in stock market history more clearly illustrate the risks of buying into “hopes and dreams” than the technology bubble of the late 1990s and early 2000s.  Companies with no earnings and nonsensical business plans eventually ceased to exist and are now long forgotten.  However, most of the well known technology firms from 2000 continue to exist today and have tested business models that generate consistent profitability.  However, investors are so disillusioned that valuations have plummeted.  This raises the question:  Are technology companies now “value stocks” that should pay large dividends?

The question of technology firms’ “payout problem” was the subject of an article this weekend in Barron’s.  Andrew Bary makes many of the familiar points regarding the valuation of companies such as Hewlett-Packard, Microsoft, Intel, and other former high fliers that now trade in value territory based on earnings multiples.  We recently published a favorable article regarding Microsoft making some similar points.  Barron’s points out that few technology companies are paying significant dividends. Intel’s 3.5 percent payout is an exception and Microsoft also pays a modest dividend of 2.2 percent but clearly the potential for much larger dividends exists.

Why Hoard Cash?  Look at the Incentives…

Why are technology CEOs so reluctant to pay dividends and prefer to pile up huge amounts of cash on the balance sheet?  The motivation behind cash hoarding for technology firms seems to fall into two categories.  First, technology CEOs have a mindset in which talk of growth is paramount.  Analysts expect this focus and “growth” investors will abandon a company that admits limits to growth by paying dividends.  Second, compensation plans for technology CEOs usually rely heavily on options with a fixed exercise price.  Paying large dividends reduces the intrinsic value of the options because cash is exiting the business.  Additionally, CEOs may believe that a permanent revaluation of the company as a slow growing “value” stock could prohibit multiple expansion that will increase the value of options.

However, the reality may be quite different in terms of how the market reacts to higher payouts.  Many investors are legitimately afraid of high levels of cash on the balance sheet due to  concerns that expensive acquisitions may be pursued.  HP’s acquisition of 3Par is the latest example.  Paying a larger percentage of free cash flow to investors could provide reassurance and also would impose discipline on management.

Barron’s also accurately points out that some investors will be attracted to technology companies based on larger payouts.  The incoming group of income oriented investors could very well make up for the exit of investors seeking “growth”.  As Warren Buffett and others have often said, the distinction between “growth” and “value” investing is a  false one to begin with.  Ultimately, management should retain earnings only when the prospect of internal reinvestment or acquisition exceeds a hurdle rate that is higher than what investors could achieve for themselves if they take possession of the excess cash.

Look at Share Ownership, not Option Holdings

While it is impossible to predict which technology companies will increase payouts going forward, one clue could involve the level of stock ownership by management.  If the CEO has a large ownership interest, as opposed to merely holding a large number of options, he or she would benefit from distribution of the cash just like other shareholders.  When Microsoft instituted a regular dividend in 2004 and paid a one-time special dividend of $3.00, many observers believed that this was due to Bill Gates and Steve Ballmer’s large ownership position in the company.

With the dividend tax set to increase in 2011, it would not be surprising to see special dividends paid out later this year.  Companies with high levels of insider ownership are much more likely to make such a move.

Disclosure:  The author of this article owns shares of Microsoft Corporation.