Do Dividends Lower Stock Prices? Part II

by: Larry Swedroe

Summary

Some investors have a hard time accepting that when a company pays a dividend, the payment results in a permanent, relatively lower price.

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.

If you believe dividends don’t lower the price by the amount of the dividend, you also must believe that not paying them would not raise the price.

In a previous post, I noted that 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).

In the previous post, I presented a series of examples that demonstrate why dividends permanently lower stock prices. And still there remained some investors, for whatever reason, who remained unconvinced. With that in mind, I thought I would come up with a specific example that would help make it even clearer that dividends lower prices. The best example I could think of is with REITs. The reason is that to qualify as a REIT, a company must not only have the bulk of its assets and income connected to real estate investment, but it must also distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends. With a REIT paying out at least 90 percent of its income, it should be easier to see the impact that paying dividends has on prices. With that in mind, let's take a look at the historical evidence on Vanguard's REIT Index Fund (VGSIX).

The fund's inception was on May 13, 1996. The fund went public at $10 per share. Almost 18 full years later, on May 6, 2014, VGSIX closed at $24.13. The fund reports that returns since inception were 10.8 percent. Over the period the fund paid out total dividends of $14.73. With those facts in mind consider the following:

First, if you believe that dividends don't lower the price by the amount of the dividend, then you also must believe the corollary that not paying them would not raise the price. Note that the price only return of VGSIX was just over 5 percent. In other words, while REITs were returning almost 11 percent, if this REIT, which is just an index of REITS, had never paid out a dividend it would have earned less than half the returns of the REIT sector - assuming you believe dividends don't impact prices.

Second, consider that if VGSIX had not paid a dividend, even if it put the cash accumulated by not paying any dividend in a mattress the fund whose underlying assets are trading at a value of $24.13 would have an additional $14.73 in cash. Do people really believe that the fund would not have a value of $38.86? To believe otherwise means you believe that the $14.73 in cash is not worth $14.73.

Third, now consider what would have happened if the tax rules didn't force the payment of dividends and the REITs in the fund had, instead of paying dividends, retained the cash and used it to pay down debt. Not only would the REIT have net assets worth at least $14.73 more, but the earnings would be higher because the company's would have had lower interest expenses. All else equal investors will pay more for a company with higher earnings.

Fourth, now consider what would have happened if instead of paying down debt the REITs had used the cash to buy back their stock. While the underlying assets and total earnings would be the same as if dividends had been paid, there would be far fewer shares. Thus, the NAV per share would be much higher than the $24.13.

And finally, it's also possible that if instead of being forced to pay dividends, the REITs were able to retain the earnings and invest in other properties. Since we know that the REIT sector earned 10.8 percent of the period, it's hard to imagine how further investments would not have resulted in greater earnings, and thus a higher NAV than $24.13. In fact, we should expect it to be sufficiently higher to have provided a 10.8 percent return (the same return as if you had reinvested the dividends).

Hopefully, the example of VGSIX makes clear the impact that dividends have on prices. It's also important to note that nothing said above has anything to do with whether a company should pay a dividend or not. That decision should be based on the company's ability to efficiently deploy its capital. If it cannot earn its cost of capital with any "excess" cash not needed to run the business, it should return the capital to shareholders so that they can deploy it more efficiently.

And to be as clear as possible, here's some other things I'm not saying:

  • I'm not saying that the price might not go up after the dividend is paid.
  • I'm not saying that the company might or might not have better things to do with its cash (it may invest it wisely; it may squander it on useless projects).
  • I'm not saying stocks that pay dividends do better or worse either in growing their business or in providing returns to their shareholders.

What I have been doing is providing the basic math, things that shouldn't have to be debated. All the other points can be (and have been) researched and debated.

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.