There are many investors who have a hard time accepting the fact that when a company pays a dividend the payment results in a permanent relatively lower price (relative to what the price would have been the dividend had not been paid), not just a lower price on the day it makes the distribution. The problem results from the fact that over time, as long as a company earns more than it pays out in dividends, the stock price will eventually increase to above the price it was before the dividend was paid (assuming valuations, or P/E ratios, remain the same or rise). Hopefully, the following examples should clarify why stock prices are permanently lowered in relative terms.
First, consider that stocks have returned approximately 10 percent per year. Let's assume that 5 percent of the return came from dividends and 5 percent from increases in prices. However, there are lots of stocks that paid no dividends. In fact, over 60 percent of U.S. stocks no longer do. Did the stocks that paid no dividends return just 5 percent? The answer is no. And while dividend paying stocks have outperformed non-payers over the long term, that's because there is a relatively small group of stocks that have poor returns (such as small growth stocks) and they tend to not pay dividends. For example, while the market has returned about 10 percent, small growth stocks (which tend not to pay dividends, or pay lower dividends) have returned just 9.2 percent. When we adjust for risk factors (such as market capitalization and price-to-book ratios), the stocks that pay dividends have the same return as the stocks that don't. In other words, the non-dividend payers had their shares appreciate about 10 percent a year, and the dividend payers had their shares appreciate 5 percent a year, and they received another 5 percent return in the form of dividends. The result is that their share prices are lower.
The following example will also show why the price is permanently lower in relative terms. Company A trades at $40 a share, earns $2 per share (its P/E ratio is 20), and with 500 million shares outstanding it has a market capitalization of $20 billion. And it earns a total of $1 billion a year. Now assume that over time the company has paid out $10 a share in dividends. We'll now undo the dividends and put the $10 per share back on the balance sheet (without even considering any earnings that the payouts could have provided had they been retained). With 500 million shares, the $10 worth of dividends is $5 billion. At the very least, the company should now be worth not $20 billion, but $25 billion, as it now has $5 billion more in cash. With 500 million in shares, the stock would trade not at $40, but $50. And this ignores the higher future expected earnings from the investment of the cash it did not have before.
Instead, now let's assume the company uses the $5 billion to buy back shares at the market price of $40. The company will be able to buy back 125 million shares, reducing the outstanding number of shares to 375 million. The company still earns the same $1 billion. However, with just 375 million shares, the company now has EPS of $2.67, and trading at a P/E ratio of 20 (it's the same company with exactly the same future expected earnings), the stock will be at not $40, but $53.4.
Another assumption is that the company uses the cash to repay debt. The company would now have $5 billion less in debt. Thus, just as in the case of the company having $5 billion more in cash, with $5 billion less in debt, the stock will be worth $5 billion more, or at least $50 per share. However, future earnings would now be higher due to the interest savings. In addition, in both this case and in the case of holding the cash, the company's leverage would be lower, making it a less risky company. Thus, it would likely trade at a somewhat higher P/E ratio.
A third example will also illustrate that dividends lower the share price. Let's assume Company A is trading at $10 per share and has 1 billion shares outstanding. On March 30th, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) agrees to buy the company and pay $12 billion, a 20 percent premium. The deal will close on May 1. On April 1, Company A's board meets and declares a special dividend of $1 per share, or $11 billion, to shareholders of record on that date, to be paid on April 15th. When the deal closes on May 1, will Berkshire still pay $12 billion for the company? No. It will adjust the price for the reduced amount of cash on the company's balance sheet. It will pay just $11 billion, or $11 per share. Whenever an acquisition is made, the price is adjusted at closing for these type changes in the balance sheet.
Dividends are not a free lunch. They return the capital the company has to its shareholders, reducing the value of the company. In addition, the company no longer has those assets to invest. Now that doesn't mean that the company should not pay dividends. If the company believes investments it makes will not provide a return at least equal to its cost of capital, it should distribute that "excess" capital to shareholders. On the other hand, if it believes it can earn more than its cost of capital, shareholders are best served if they retain the earnings - and if shareholders need cash, they can create their own home-made dividend by selling the amount of shares required to generate the same amount of cash as a dividend would have. This is the point Warren Buffett made in his 2013 annual shareholders letter. Buffett showed the math behind his reasoning for not paying a dividend despite many shareholders being upset with him because he was retaining all that cash.
Dividends are not a free lunch. The only free lunch in investing is diversification, which done properly, reduces risk without reducing expected returns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.