There are a number of misconceptions concerning the impact of dividends on stock prices.
It is important to understand that share price is not the same thing as "company value".
Dividends and total return go hand-in-hand, but there is more than one way to profit in the stock market.
In a recent article written by Larry Swedroe, the question was asked: "Do Dividends Lower Stock Prices?"
In his article, Larry says:
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.
So, dividends paid not only result in lower stock prices, but a "permanent relatively lower price." But in the next sentence, Swedroe points out what appears to be a contradiction:
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).
How Does That Work?
I have to admit that I'm a little confused here. If companies that pay a dividend cause the price of the stock price to be permanently reduced, then how can the simple factor of earnings growth that comes at a larger rate than dividend growth drive the price of the stock higher?
Later in the article Swedroe points out an illustration, comparing dividend paying stocks to non-dividend paying stocks, where he says:
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.
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.
If dividend paying stocks had a 10% appreciation on an annual basis (5% price appreciation and 5% from dividends) and non-dividend paying stocks had 10% appreciation, then both types of stocks would have the same total return. So, how does one arrive at the conclusion, then, that "the result is that their (dividend paying stocks) share prices are lower?"
Assumptions Can Be Deadly:
The author makes a number of assumptions in his example of dividend paying stocks and non-dividend paying stocks. First, he makes the assumption that stocks are appreciating 10% a year. Second, he assumes that dividend paying stocks are appreciating 10% with a split of 5% appreciation and 5% dividends paid.
But, are those assumptions reliable? As a universe of dividend paying stocks and non-dividend paying stocks, perhaps the numbers are correct. But, in order to use the universe of stocks and arrive at this magical 10% number, can you imagine the number of individual stocks or the number of individual indexes you would have to own? Quite a daunting task.
Investopedia defines a "Dividend Aristocrat" as:
A company that has continuously increased the amount of dividends it pays to its shareholders. To be considered a dividend aristocrat, a company must typically have raised dividends for at least 25 years. More specifically, the company needs to have a managed dividend policy that increased its dividend every year for those 25 years.
David Fish, a contributor here at Seeking Alpha, publishes a list of companies that are referred to as the Dividend Champions, Contenders, and Challengers. You can find this list here. These lists are made up of stocks that have increased their dividends for 5 years, 10 years, and 25 years. Worth a look.
Getting back to the Dividend Aristocrats. What I've done is put together a list of the DAs and shown the 5 year performance, annualized return, and the change in price for each of the companies in the group. I've eliminated Abbott Labs (NYSE:ABT) from this list, as the company split into two entities last year.
In every case, the price of the stocks that make up the Dividend Aristocrats has increased over the last 5 years. It is clear that even though these companies pay dividends every quarter and have increased those dividends annually, the price of the price of the stock has grown.
Conclusion and Summary:
There is no right way or wrong way to invest. Some people will choose to purchase dividend paying stocks and some will choose to purchase non-dividend paying stocks. There are even some people (like me) who own both.
When you decide to own individual stocks, you are going to perhaps take on greater risk than someone who chooses to invest in Index vehicles. Investing in individual stocks, regardless of their policy of paying or not paying dividends, requires that the investor become a stock picker. This is not something that every investor wants to be and that is fine.
While one might arrive at some "standard" of measurement for total return in the universe of dividend paying stocks and non-dividend paying stocks, the fact remains that unless one is buying an Index, the individual stock investor is not participating in that "standard" universe and as a result will have results that may be more or may be less than the "standard."
While one might argue that dividends reduce the value of a company, that is not the same as saying that dividends reduce the price of a company. As the table above shows, the price appreciation in the Dividend Aristocrats came in spite of the dividends paid and increased over the last 5 years.
Companies are going to continue to pay and increase dividends as earnings growth will allow them to do. You can either chose to invest in companies that pay a dividend or invest in companies that do not. Your decision is not going to change the fact that there will be companies that continue the practice of paying dividends to shareholders. Don't become Don Quixote over it.
Are dividends a "free lunch"? Of course not. They are an indication, however, especially when they are increased annually, that good things are happening in the underlying business that is paying them to shareholders.
Disclosure: I am long MMM, AFL, T, BDX, BMS, CVX, CL, CLX, KO, EMR, ITW, JNJ, KMB, LOW, MCD, PG, TGT, WAG, WMT, GWW, SYY, VFC, PPG, PNR, DOV, HRL, BF.B. 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.