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The proper way to view most stocks’ rate of return is to look at total return. And it is irrelevant, except for personal income tax implications, how much of that total return comes from dividends versus stock price gains.

There are cases in which a dividend can hurt total return – as when a failing company continues to pay dividends, which worsens its financial weakness and threatens its very survival. An example would be General Motors (NYSE:GM) during the years leading up to its bankruptcy. Likewise, there are some cases in which payment of a dividend truly benefits investors, such as with Microsoft (NASDAQ:MSFT) or Cisco (NASDAQ:CSCO). Both companies have proven unable to invest their huge cash hoards effectively in recent years. Instead they pay out increasing dividends, which investors can then reinvest in the shares of the same or additional companies, rather than lose out as both companies’ invest their excess cash at near-zero interest rates in the money markets.

But, for the vast majority of companies, which are neither piling up excess cash fortunes nor sinking toward bankruptcy, the dividend payment policy or lack thereof is irrelevant to an investor’s total return.

Payment of cash dividends has no effect on investors’ total return because each dividend payment reduces the value of a company’s stock by an equal amount. To give an extreme example, if you and I decide to get together and purchase a restaurant that has $200,000 annual income plus $10 million in its corporate bank account, we might come to agreement with the seller on, say, $11 million as a fair purchase price for this business. However, if, on the day of the closing, the seller informs us that he has paid himself a special dividend of $9.9 million and there is now only $100,000 cash in the corporate bank account, are we likely to still be willing to pay $11 million? Clearly not; the market value of the restaurant will have dropped precipitously because it holds less cash.

Now, you may object that for most stocks, the cash holdings are a relatively small part of the market value, and, while they may count for something, the stock market may not incorporate the value of the cash into the stock price in a linear fashion. In other words, maybe an added dollar of cash only adds pennies to the share price. That is certainly possible.

But how does that get us to a point where payment of a dividend actually enhances a stock price? If paying a steady and reliable dividend, as in the case of Johnson & Johnson (NYSE:JNJ), for example, does enhance its stock price, then buying such a stock right now surely fails to capture that enhancement, since the steady, reliable payments are already known by all and must be already reflected in the stock price. A buyer of such stock today will pay a premium in the form of a higher stock price (if you believe in this positive dividend effect). Today's buyer will gain from that premium only if investors are willing to pay an ever higher and higher premium for steady, reliable dividends as time goes on. While that is certainly possible, the reverse might occur. Just ask past investors in AIG (NYSE:AIG), General Electric (NYSE:GE), Citigroup (NYSE:C), Bank of America (NYSE:BAC) and even Lehman Brothers, which had experienced years of steadily increasing dividends, until the party ended and both dividends and share prices plummeted.

Clearly, the current low interest rate environment has “forced” some conservative investors into buying high dividend paying stocks as a bond substitute. This has likely propped up the stock prices of such high dividend payers as Verizon (NYSE:VZ), AT & T (NYSE:T), Merck (NYSE:MRK) and Pfizer (NYSE:PFE). Therefore, these high dividend payers are likely somewhat overvalued at the present time because this premium surely will disappear, resulting in a relative decline in stock price, as soon as interest rates rise sufficiently for investors to stop viewing high dividend payers as temporary bond substitutes.

With the exception of avoiding very high dividend paying stocks, I continue to view the dividend paying policies of most stocks with indifference. For those who see the payment of dividends as an enhancement to a stock’s price, I wonder why such investors do not focus on non-dividend paying companies, such as Apple (NASDAQ:AAPL), so as to capture any such premium before it is built into the stock price, rather than afterward, when the premium has already provided its benefit to investors.

Source: The Misplaced Mania Over Dividend-Paying Stocks