In this article, I introduce the concept of dividends. Dividends are often stated as a major source of investment return.
In this post I’ll address:
- How dividends are commonly portrayed
- Define dividends
- Show an example of the reality of dividends
- Address how dividends can be deceiving
How dividends are often portrayed (“Free Money”)
Dividends are often portrayed as some sort of “free money” or other type of miraculous key to successful investing. There are many strategies on the internet about the benefits of “dividing paying stocks” or “dividend growth investing.” All of these strategies follow a common theme.
When you buy stock in a company that pays dividends, you can receive a regular income source from the company. That company will pay you every quarter for holding their stock, which you can reinvest and use to buy more stock or take as cash to spend. This idea boasts two benefits. First, when you are in the wealth accumulation phase (working, saving for the future/retirement, etc…) your dividends can be used to buy a greater ownership share in the company. Second, when you are in the wealth draw-down phase (retired, spending your savings and investments) your dividends can be a replacement for your working income. This is where the phrase “live off your dividends” comes from.
Both of these concepts are true, but they are also deceptive. I’ll address why they are deceptive later in the post. Before we can address that, we need to properly define dividends.
True definition of Dividends
A dividend is the portion of a company’s earnings which the company chooses to return to shareholders in the form of a cash payment.¹
This definition is important. There are two key points.
First, that dividends come from earnings. They do not appear out of nowhere, and because it is real cash paid to an investor, you can’t fake dividends. At least not for long. This is why consistent dividend payments or changes in the amount of dividends paid is often used as an indicator of the strength of quality of a company. The counter example is a company such as Enron, where they reported great financial results. However, these results weren’t backed up by anything. If Enron had been paying a regular dividend, their fraud would have been caught much earlier because they wouldn’t be able to lie about cash they pay to shareholders.
Second, that a company chooses to return this money to shareholders. Dividends are not guaranteed, they are voluntary. Each time you receive a dividend, company management made a conscious choice to pay that cash to you. This decision is made each and every quarter.² Just because a company is shown to be paying a dividend when you buy it, there is no guarantee that they will pay that same amount the next quarter. The company could easily choose to reduce the dividend payment, or stop paying dividends altogether.
The takeaway from this is that you have to be careful about making investment decisions solely or even with a focus upon dividend paying companies. On it’s own, the dividend payment history of a company will not tell you anything about the future performance of the company. A company that has been paying consistently increasing dividends for decades could stop those payments tomorrow, and a company that has never paid a dividend could begin doing so. This is one reason why it is important to focus on the fundamental strengths and weaknesses of the business and not on a company’s stock price or dividend history.
Example – The reality of dividends
When a company pays out a dividend the price of the company’s stock and the value of the underlying business change. Both of these issues are important.
Let’s use a hypothetical company priced at $100 per share which earns $10/share a year in profit. Our hypothetical company has assets of $150 per share of which $100 is cash and $50 are other assets such as buildings, land, and equipment. They also have $50 per share of debt in the form of loans to the bank. This means that shareholders equity, or book value, of the company is also $100 per share. ($150 assets – $50 debt).
In this example our hypothetical company has a book value of $100 per share and a price of $100 per share. This almost never happens in real life, as the market no longer uses book value as the basis for a value of a company anymore. Most companies are valued based upon how much money they will earn in the future, and not how much they have currently.
The $10/share of annual profit equates to $2.50/share each quarter. Company management decides that they would like to pay a $1.00 per share dividend this quarter. So what happens?
Based upon how dividends are portrayed as “free money” one would expect that the company pays out the dividend and neither the company’s price or value is effected. That isn’t true though.
When a dividend is paid, the cash paid to each shareholder is deducted from the cash held by the company. This reduces the book value of the company when it pays you a dividend. Therefore, the value of the company is reduced every time it pays a dividend. In addition, when a dividend is paid, the stock price of the company is automatically adjusted by the stock market by the amount of the dividend. Therefore, in our example, if the company pays a $1.00/share dividend, then the stock price would automatically adjust from $100/share to $99/share after the dividend is paid. The same would drop would occur in the book value of the company.
We are going to look at two points in time, before the dividend is paid and after the dividend is paid. Let us assume that you own 10 shares of company stock prior the dividend payment.
Before the dividend is paid:
You own 10 shares of stock, priced at a market value of $100/share. You have $0 in cash. The market value of your portfolio is $1,000.
You own 10 shares of stock, with a book value of $100/share. You have $0 in cash. The true value of your portfolio is $1,000.
After the dividend is paid:
You own 10 shares of stock, priced at a market value of $99/share. You have $10 in cash. The market value of your portfolio is $990 in stock + $10 in cash = $1,000.
You own 10 shares of stock, with a book value of $99/share. This is because the company only has $99 of cash per share after paying you $1 of their $100/share of cash. The true value of your portfolio is $990 in stock + $10 in cash = $1,000.
Dividends can be deceiving
The first deception that I mentioned above, was that dividends, when reinvested, allow you to purchase a greater share of ownership in a company over time. This can be true, but understates some problems. As I have just shown, when you receive a dividend you are not actually increasing the value of your portfolio in any way. You don’t magically have more money with which to buy a larger ownership share in the company. If you started with $1,000 of ownership in the company, you ended with $1,000 of value. If you don’t reinvest your dividends, then you end up $990 of ownership in the company, and $10 of cash. If you reinvest your dividends, then you end up with $1,000 of ownership in the company. The only change which has taken place is that now you own more shares which are each worth less individually. The overall value is the same.
Note, this can increase your ownership share without increasing the value of your portfolio. If you choose to reinvest your dividends then you will now own more shares. Assuming only some of the people who receive the dividend reinvest it, then you’ll now own a larger part of the company. However, if everyone were to always reinvest their dividends, then everyone would increase their number of shares at the same rate. You wouldn’t actually be increasing your ownership in the company. You’d simply be owning more shares of an ever larger number of shares. This isn’t a realistic situation, as it would imply that no one ever sold any shares of the company. It is an important distinction though.
The second deception is that you can simply live off of your dividends in retirement. This can be true, if you have a large portfolio of stocks that regularly pay dividends. However, as I have shown, there is nothing miraculous about dividends. If you were to spend the $10 of cash dividends, it would reduce your portfolio value to $990. This isn’t any different than selling $10 worth of stock from a $1000 portfolio and ending up with a $990 portfolio. The only benefit of spending only your dividends in retirement is that dividends can provide an easy tool for withdrawing a sustainable portion of one’s portfolio. This is based upon management only paying dividends which they can steadily pay over time and not decrease. Shareholders tend to get upset if management stops paying or reduces dividend payments. As mentioned above, dividends are voluntary so this doesn’t prevent it from happening. However, it does make the reduction of dividends less likely.
Conclusion
It is important to remember that dividends are simply the portion of a company’s earnings which management chooses to pay out to shareholders. This means that dividends are tied always to the performance of the company. Dividends are also voluntary, so they shouldn’t be solely depended on. Finally, the payment of dividends doesn’t actually increase the value of your portfolio. They can be beneficial, but they aren’t free money.
Is this a view on dividends you haven’t heard before? Please add your thoughts to the comments below.
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¹Dividends can be paid in the form of cash or stock. However, I am only considering cash dividends in this post as they are the predominant form of dividends.
²Most dividends are paid quarterly. Some companies make dividend payments only once a year, or make special dividend payments outside of a regular payment schedule. My example assumes quarterly dividend payments.
