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With interest rates at historical lows (well, let's face it… interest rates are at zero) a lot of investor focus is turning to dividend paying stocks to provide cash. Whereas money market funds used to provide at least a little bit of return, these funds are now nothing more than giant mattresses where billions of dollars get stuffed. Whether these mattresses are really as safe as your pillow-top Serta at home is a question for another time. Any return that your money market might give you is quickly swallowed up by inflation, so many investors look to companies that return cash to investors in the form of a dividend.

Warning: I may ruffle some feathers with what you're about to read. Please just keep an open mind. I'm not going to say that dividends are bad, but that they're just not what many people believe them to be. (See articles I, II, III.) Too many investors (and I include 'traders' in that category and readily admit that I cannot provide a clear definition to distinguish between the two) believe that they're actually making money through dividends.

That's not true. So let me define a few things - and make an assumption or two - for the purposes of this article.

First, I'm going to assume that anyone reading this is interested in increasing his or her net worth. Besides getting rich by having your stock portfolio go up in value, you also increase your net worth by making money elsewhere in an amount that exceeds your expenses.

But what does it mean to actually 'make money'? This is where we need to distinguish between 'profit' and 'cash flow' and understand their impact on your net worth, and this will expose dividends for what they really are: a false god.

Second, the following terms as I define them support my thesis that you don't make money through a dividend. One can certainly disagree with my definitions, but each one is defined such that if you really want your net worth to increase, then I think you have to agree to accept these terms.

  • Profit: Something that increases your net worth. That's pretty simple. Another term for profit is "making money."
  • Income: Money you receive for something other than a repayment of debt. If your income exceeds your expenses (losses), then you have a profit that increases your net worth.
  • Cash flow: Same as income above. However, cash flow that is equally offset by losses does not increase your net worth and therefore is not profit.

We all know that a dividend is a payment of cash to shareholders of record on or before the record date. Here's an example. The SPDR S&P 500 ETF (NYSEARCA:SPY) pays a dividend every quarter. This past September, the dividend was $0.78 payable to shareholders of record on September 25th. If you wanted that dividend, you needed to buy the stock no later than September 20th to be considered a shareholder of record. If you bought SPY one day later on the 21st, then you didn't get the dividend.

So what happens to the stock price between the 20th when it includes the dividend and the 21st when it no longer includes the dividend? The stock price is adjusted lower by the amount of the dividend on the 21st - the date known as the "Ex date" or the "Ex-div date." It means the date on which the stock trades "excluding" the value of the dividend.

While most investors nowadays understand that the stock price has to be adjusted lower, there are still a few holdouts that don't know - not unlike the occasional Japanese soldier holed up in the South Pacific that hasn't heard the news of the war's end.

Don't get confused here. On ex-div day the stock might trade up, down or sideways due to market forces. But regardless of the price on the ex-div date, it's going to be lower by the amount of the dividend than if the dividend had not been paid.

Now this is where the discussion can drag on till the wee hours, but can we agree that in simple terms the stock price represents the value of the company? Part of this value is the company's cash. If we freeze the value of every other asset and liability and focus just on the cash, then it must hold true that the value of the company will drop in an amount equal to the cash that it gives away with the dividend.

The stock price has to drop. That's why it makes sense that an investor buying SPY before the ex-date should have to pay $0.78 more than the investor that buys the stock on or after the ex-date: the latter isn't going to be getting that cash payment.

I don't want to beat a dead horse, but I find it helpful to understand a concept when it's magnified or taken to an extreme. Take a look at Armstrong World Industries (NYSE:AWI), which paid a special dividend of $8.55 with the stock going ex-div on March 30, 2012. This is almost a perfect example.

(click to enlarge)AWI Special Dividend

On March 29 the stock closed at $57.36. The next day, ex-div day, it opened for trading at $48.80, down $8.56. Why the penny difference between the dividend amount and the stock price on ex-div day? Market forces. Remember, no one knows what the stock price is going to be the next day, but again, whatever the price is, it's going to be lower by the amount of the dividend than if the dividend had not been paid.

So if you receive a cash payment from your dividend, but your stock drops by an equal amount, do you have a profit? Have you made money? Or do you simply have cash flow that does nothing to increase your net worth?

In mathematical terms (tax implications aside), receiving a dividend really isn't much different from taking money out of savings and putting it into checking. Yet you still have the market risk of the stock!

But what about the yield? Dividend yield is one of the most useless and misunderstood numbers you can look at. It's just a number. Nothing more. Take the total value of dividends paid in a year and divide that by the current share price and you get the yield. As the stock price goes up, the yield gets smaller. As the stock price drops, the yield gets bigger. This assumes the dividend rate remains unchanged. So to get a bigger yield, you want your stock to go down. Does that make any sense? Of course not.

And doesn't the term "yield" kind of imply that you're receiving some sort of return? That's how it's misunderstood. The only way you're going to actually get this so-called yield is if the stock goes back up in an amount equal to the dividends the company pays out. That's quite an assumption. And even if the stock DOES go back up in an amount equal to the dividend, you're making money on the stock appreciation - not the dividend. So in reality, here's what a dividend represents:

Dividends = cash flow + market risk

Since we agreed that cash flow doesn't equal profit, then when you buy a dividend-paying stock, you're really getting nothing but the market risk of buying the stock - the same as you'd get by buying a non-dividend paying stock. Said another way, "a dividend is a return OF your money; not a return ON your money."

And that's the bottom line.

The dividend itself is meaningless to your net worth, or even possibly detrimental if we take taxes into account, but let's not open that can of worms. If you want, or need, the cash flow that dividends provide, I'm not saying there's anything wrong with that. I'm just pointing out that dividends play no part in your profitability, and I hope that understanding this makes you a more informed investor.

Source: Beware The False God Of The Dividend