Dividend investors typically pick stocks based on their dividend performance, be it yield, growth, sustainability or a chosen blend of these and other factors. Dividends are normally paid in cash and income investors love these regular payments as they can provide a nice and stable income stream.
So-called scrip dividends, on the other hand, are not paid in cash but in additional shares issued by the company. However, investors willing to receive cash regularly can always sell the additional stock to create an income stream.
One way or the other, it feels good to receive those dividends. They make your bank account grow. It feels so good that in fact many dividend investors choose to reinvest these proceeds in order to create a virtuous circle of compounding.
So good so far.
However, the tricky piece is that despite how good they make you feel, dividends do not make you any wealthier. They just move your wealth around, from your left pocket into your right pocket, as proposed by Modigliani and Miller.
The example below tries to illustrate in a simple manner the financial dynamics of how dividends affect investor's wealth. I have made the simplifying assumption that the company is priced at book value - a different assumption would not change the conclusion. Our fictitious investor initially owns 20 shares in a company with 1,000 shares.
Six possible scenarios are then considered:
- The company does not distribute any dividend
- The company does not distribute any dividend but the investor sells 1 share
- The company distributes a $0.5 cash dividend
- The company distributes a $0.5 cash dividend and the investor reinvests it
- The company distributes a $0.5 scrip dividend
- The company distributes a $0.5 scrip dividend and the investor sells the scrip
The balance sheet for the company in these scenarios is shown below.
|Company Balance Sheet||1||2||3||4||5||6|
|Company Info||Book Value||10,000||10,000||9,500||9,500||10,000||10,000|
|Price per share (@ Book Value)||10.00||10.00||9.50||9.50||9.52||9.52|
As could be expected, from a company point of view, scenarios 1 & 2 are the same, and so are 3&4 and 5&6.
The takeaway for 2&3 is that, when a company distributes cash dividends, it reduces its assets (specifically its cash) and its equity (specifically its retained earnings). Most relevant, its price per share is reduced to reflect the smaller size of the company assets after the distribution has taken place.
As for 5&6, when a company issues a scrip dividend, its assets remain the same but a change is operated in its equity. This takes place by relabeling retained earnings as share capital. Again most relevant, its price per share is reduced to reflect that the same assets are now spread across a higher number of shares (dilution).
Now let's look at the balance sheet of our investor in the different scenarios. Stock assets are just the number of stocks times the price per share, while cash assets are the total proceeds received in cash from the company either through dividends or stock sales (taxes or transaction costs not taken into account), net of any stock purchases.
|Investor Balance Sheet||1||2||3||4||5||6|
As can be seen from the balance sheet table, if a company does not distribute dividends (scenario 1), our investor can still receive cash by selling shares (scenario 2) to end up with the same balance sheet as if the company had distributed a dividend (scenario 3).
If our investor goes the compounding way by receiving and then reinvesting dividends (scenario 4), he will just curiously end up in the same place as if the company had never distributed dividends (scenario 1).
As for scrip dividend, receiving a scrip dividend (scenario 5) is exactly the same as not receiving any dividend. That is basically because a scrip dividend is not a distribution of assets from the company to its shareholders. In that sense, it just resembles a stock split. Finally, if our investor sells its scrip dividend (scenario 6) he will be just creating cash by selling its positions in the company, similarly to what he did intentionally when just selling stock (scenario 2) or unintentionally when receiving a cash dividend (scenario 3).
It is particularly important to highlight this last point: a cash dividend distribution is, from the point of view of the shareholder, equivalent to a divestment in the company. To make it more visual imagine the company has no cash but still wants to distribute a dividend: it would need to sell part of its assets (divest) to satisfy shareholders hunger for cash. Alternatively (but equivalently) it could of course increase leverage, but that is in a sense taking creditors - as opposed to shareholders - to invest funds in the company.
Investors can be sometimes concerned by dilution (see the % ownership detail above). It is true that our investor starts with a 2% ownership in the company and his stake gets diluted whenever he sells stock (scenario 2 or scenario 6). On the other hand, his position only grows when he receives cash dividends and reinvests them in the company (the compounding trick).
However, investors must be aware that owning a 2.1% stake in a company worth $9,500 (scenario 4) is the same as owning a 2.0% stake in a company worth $10,000 (scenario 1). In other words, our investor owns $200 worth of company, no matter how big or small the company is. Assuming that the return on assets is not affected by the size of the company, a bigger company would produce higher returns than a smaller company. In practice, this offsets the smaller portion the investor will receive on future earnings. Dilution could only be relevant to avoid losing control of the company, but this is possibly no worry practically for most individual investors.
Dividend distributions do not create wealth for shareholders. They can make you feel good and many investors do indeed love them, but they just do not add value. What cash dividends do for you is shift value from one of your pockets (stock) into another (bank account cash), exactly in the same manner that selling stock would.
With that in mind, I do not intend to say dividends are bad. They do not destroy value either after all (except for tax implications), so loving them comes at no cost. And that is possibly why I personally still love them so much. Call it free love.