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Over the short term the market can be irrational and inefficient. However, over the longer term the market is efficient and the actual value of a stock will be followed by the price, despite some short term over or under valuations caused by the irrationality of some. When looking at a stock I try to determine its value, because I know price will eventually follow value. When evaluating different parts of a stock I am constantly asking myself, how does this effect the value of the business? So naturally when looking at dividends I ask myself that question. The answer, dividends have no positive effect on the underlying business and rarely if ever have a positive effect on my investment in that business.

When a company pays out a dividend, it is using cash generated from its operations. Since the cash generated by the business goes to an outside source (shareholders) not pertaining to the business, it decreases the value of the business and thus eventually lowers the price of the security by the dividend amount. The share price declines by the dividend amount that day, but it doesn't always stay there. However, over the long term the share price will decline by the amount of the dividend no matter what. The investors get that dividend money, but at the expense of owning part of a business that is now worth a little less.

Example?

Imagine there are two stocks. Both are \$100 million companies (That's their value which the price will eventually follow). They both generate \$10 million in owner earnings in one year. Company A keeps the \$10 million and simply reinvests it into their business. So their value increases to \$110 million. Company B decides to pay a dividend in the amount of \$5 million total. So they take half of the cash they generate and pay it out, and no longer retain all of that \$10 million of earnings. They reinvest the other \$5 million in their business. After that one year, company A would be worth \$110 (\$100 million plus \$10 million in retained earnings) and company B is worth \$105 (\$100 million plus \$10 million in earnings minus \$5 million in dividends), but yields a dividend of \$5 million (total). So what would you rather own, something that's worth \$110 million or something that's worth \$105 million and pays you \$5 million? They are both worth the same. The dividends that the investor in company A is deprived of will be made up for in capital gains.

In fact, if each company earns 10% of their value next year as well, company A will have \$11 million of retained earnings and company B will have \$10.5 million in retained earnings because they invested less in their business. So now company A is actually worth more.

All this is in a tax free world as well. In the real world, both companies' earnings would be taxed. Then when company B pays a dividend, that money will be taxed again. The investor in company A will only pay a tax on his companies' earnings when he sells, and he will face a much favorable tax rate. (This is assuming the company is not a REIT or any other that has favorable tax implications on dividends).

When should a company pay dividends?

The only time a company should even consider paying a dividend is when they cannot achieve higher returns on their retained earnings than their investors could, and their share price is too high to warrant a buyback. Buybacks are more favorable than dividends because they are tax efficient, but they are only positive when the stock is fairly or undervalued. Also, a company should pay out a dividend if they are a net net because in that case, the value of the cash or marketable securities could be unlocked easier.

In my opinion, portfolio strategies that focus mainly on dividends and dividend yield is foolish. Why? Well companies that pay out high dividend amounts are basically saying, "We cannot achieve satisfactory returns by increasing the scope of our operations, and our share price is too high to warrant a buyback." None of those two traits are favorable. If a company is so inefficient or unprofitable to the point where it cannot expand operation and still be profitable, then do you really want to own that company? If the share price is too high to warrant a buyback, do you want to own that company? If the management is so nonsensical as to pay a dividend when it can achieve a higher return than most shareholders by expanding operations, then do you want to own that company? Therefore I believe that a strategy of buying only companies that have one or more of these qualities(not able to grow operations, high share price, dumb management) is a poor one, which is what dividend focused portfolios are.

When is it better for you when a company decides to pay dividends?

Even if a company pays a dividend and can earn higher returns through expanding operations than their investors could, doesn't mean that you couldn't earn higher returns. If a company earns 20 or 25 percent on their invested capital, then they are earning a much higher return than the vast majority of their shareholders. However, what if one of their shareholders was a young Warren Buffet who could earn returns of 50 percent per year consistently? Then for that young Buffet, he should be happy when one of his companies pays a dividend. Certainly, if you are achieving much higher returns than the majority of investors, a company paying a dividend can sometimes be a good thing for you (and maybe only you) if you can get higher returns than the company can. That company would still be doing a disservice to the majority of its shareholders though.

Some common questions and concerns you might have.

Don't dividend paying companies do better on average than companies that do not pay?
Remember, dividends add no value to the company. A company is not a stronger business just because they decided to pay a dividend. Dividends don't matter in the long run. I am dividend agnostic. A dividend paid reduces capital gains by the amount of the dividend. Any statistic that shows dividend paying companies doing better than non dividend paying companies misses the point. The reason the dividend paying companies did better is not because of the dividend, but because of the strength of the business. Most strong business happen to pay a small dividend because they think they are being shareholder friendly.

I've seen many statistics of how the market only gained 7% over the last 100 years without dividends and gained 10% with dividends. So dividends do matter right?
No. If none of those companies in the market paid dividends over the last 100 years, the market would have gained 10% because the companies would of retained those earnings and bought back shares or reinvested in their company, increasing the value and the returns over time.

But I've read dividend paying companies are safe, so I invest in them to be conservative and prudent.
The dividend has nothing to do with soundness of the business. Most mature and non volatile companies pay dividends, but the dividend itself has nothing to do with the quality of an investment or the quality of an underlying business and doesn't affect returns over time. A great company can not pay a dividend, and a poor company can pay a large dividend.

I'm a retiree. I need investment income to live off of. Spending dividends doesn't harm my principle investment.
Yes it does. The value and eventually the price of your stock will drop by the dividend amount it pays, therefore every dividend you receive decreases your principle investment by that amount. It may not feel like it but it does.

Ok, but explain this. Whenever a company announces they will cut or eliminate a dividend, their share price gets hammered, and when a company raises a dividend their share price rises. If dividends don't matter, then why is this?
That's the irrationality and inefficiency of the market. Some institutional funds can only hold dividend paying companies, therefore when a company stops paying they have to sell because its in their charter, or they perceive them as a poorer business now. This just represents a buying opportunity (or selling opportunity if a dividend is raised) because the value of the business remains largely unchanged. Actually, the value can be increased or decreased in an opposite way of the dividend. If the dividend is cut or eliminated, the stock will probably sell off. However, that can be a positive for the value of the business because now the company can use the funds set aside for dividends to increase the scope of their operations, which actually increases the value of the business (usually). Vise-Versa for a company that raises a dividend.

If there is only one thing you take away from this article have it be this.

Short term, the dividend could create an inefficiency in the price of a stock, but longer term the dividend decreases the value of the stock by the amount of the dividend paid, and therefore does not matter at all.

Disclosure: no positions mentioned

Disclosure: no positions mentioned

Disclosure: no position mentioned