Recently there has been abundant discourse on how dividends affect a shareholder's profitability. What I find so strange about the issue is the divide between the sides and the absolutism of each view. Dividend backers make broad statements that dividends enhance the profitability of shareholders, while contrarians say the opposite. I present below a logical proof as to why the benefit or harm of a dividend cannot be generalized and must necessarily be assessed on a case by case basis.
First, let us take a look at the two sides of the issue. A recent article by fellow Seeking Alpha contributor, Chuck Carnevale, which received an Editor's Pick gives an excellently presented argument that sums up the pro-dividend side of the discourse. Here is his thesis:
The most important point here is that the capital appreciation component would have been the same whether or not Acenture paid its shareholders a dividend. Moreover, the dividend added almost a full percentage point of annual return to the results. Dividends are clearly a bonus, or a return in addition to the capital appreciation component.
For the opposing view, colloquially referred to as "anti-dividend," we can reference another SA contributor, Greg Loehr, in his recent article.
When you buy a dividend-paying stock, you're really getting nothing but the market risk of buying the stock - the same as you'd get by buying a non-dividend paying stock. Said another way, 'a dividend is a return OF your money; not a return ON your money.'
And that's the bottom line.
Both articles present their arguments very well and even provide evidence to support their respective claims. My intent is not to criticize the authors or the articles, but rather the logical basis of their arguments. Each failed to address the core of the issue, which is the opportunity cost of the dividend itself.
The opportunity cost of dividends
A dividend is beneficial to a shareholder if and only if the value of it outweighs the cost. Such a generalized statement is inherently true, but only useful if we can define each aspect. So we shall begin.
- The VALUE of a dividend to a shareholder is equal to the best available use of its face value, whether that be reinvestment, or spending.
- The COST is equal to the foregone future earnings that could have been generated had the distributing company invested them. As an example, the money could have instead gone to paying down debt, in which case the foregone future earnings would be equal in magnitude to the reduction of interest payments. While there is the noise of fluctuating P/E ratios, the foregone earnings would on average eventually be transferred to shareholders in the form of capital appreciation.
The benefit or harm of dividends boils down to the disparity in reinvestment efficacy between the company and the investor. Therefore, the effect of dividends on shareholder profitability cannot be stated universally and is instead relative to both the investor and the company providing the dividend. We can, however, make qualitative statements about what conditions affect whether or not we should favor distributions.
Conditions of the investor
Generally speaking, the savvier an investor, the more returns he/she will be able to generate through intelligent investment of dividends into another outlet. This generates a slight favoring of high-yielding stocks for superior investors, and low-yielding for the less adept. To illustrate this point, let us consider two hypothetical otherwise identical companies: one that will make a distribution, and the other that will apply an equal amount of money to an acquisition at a 6% cap-rate. A particularly savvy investor who has reason to believe he/she can generate 8% annual returns through intelligent allocation of a dividend would be much better off being invested in the company paying the distribution, while a less experienced investor who can reasonably expect a 4% return on reallocated dividends would be better off with the company reinvesting at the 6% cap-rate and receiving the benefit down the road.
Beyond the skill of investors we should factor in their situations. Those needing money on a more immediate basis as a supplement to income should favor high-yielding stocks.
Conditions of the company
Assuming perfect stewardship, for any given company, the optimal level of distribution is the point at which the opportunity cost of further distribution is equal to the value to its shareholders.
The red line above represents the diminishing opportunities available to a given company. It will vary greatly between companies depending on their prospects. Essentially, we are benefited when companies distribute cash, which they cannot invest accretively, and do not distribute cash that could be better used internally. Here are some current examples of companies that wisely allocate the amount of their dividends.
First Industrial Realty (FR)
First industrial levered itself on an expanding portfolio at the unfortunate timing of right before the recession of 08. Since then, it has buckled down and made some truly impressive managerial maneuvers to work its way out. It has made progress in delevering, but still has a ways to go before reaching its target. FR is the only industrial sector REIT not paying a dividend, instead diverting all of its cashflows to internal strengthening. In my opinion, the marginal benefit of each dollar spent in this manner heavily outweighs the value of an equivalent dividend. FR is close to reaching its target leverage and may soon reinstate the dividend on its common stock.
Mack-Cali Realty (CLI)
The office sector is still struggling with oversupply. While some vacated properties can be scooped up very cheaply, there is no guarantee that such properties could get leased up. Thus, the accretiveness of even the most opportunistic purchases is questionable and office REITs are left with a paucity of opportunity. Mack-Cali responds to this dilemma by paying out one of the largest dividends in the sector at 7.1%
And a couple of companies that seem to be misallocating capital
Microsoft Corporation (MSFT)
Sitting on a mountain of cash over $60B, Microsoft simply lacks sufficient opportunities to spend it accretively. As such, its capital could be better allocated to distributions. It has made some progress through dividend raises, but much more could be distributed. Currently, MSFT yields 3.4% and has a P/E of 8.44.
Omega Healthcare Trust (OHI)
Healthcare REITs have access to incredibly high cap-rate acquisitions ranging around 9%-11%. The sale-leaseback as a means to free up capital for operators has only begun to scrape the surface. In my opinion, the vast and growing amount of money dedicated to its 7.77% dividend yield could be better spent expanding its blossoming business.
It turns out, in the prevalent and heated public discourse of the benefit of dividends to shareholders that both sides are partially right. The actual effect of dividends goes far beyond the initial accounting and must be evaluated case by case, company by company, and investor by investor.