The Real False God Of Dividends

by: David Van Knapp

In a recent article, the author stated that he would "…expose dividends for what they really are: a false god."

I'm not going to say that dividends are bad, but that they're just not what many people believe them to be….Too many investors…believe that they're actually making money through dividends. That's not true….

The author defined his terms carefully:

[T]he following terms as I define them support my thesis that you don't make money through a dividend….[I]f 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….

  • 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.

The essence of the author's point that investors do not" profit" from dividends was the familiar claim that a dividend, in effect, just moves money from one pocket to another. You owned it when it was within the company, and you own it after it is credited to you as a dividend. The stock's price drops by the same amount, so the transaction is a wash.

So what happens to the stock price…? The stock price is adjusted lower by the amount of the dividend on…the "Ex date" or the "Ex-div date."

The author acknowledged that trading activity may mask the price adjustment.

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…. If we freeze the value of every other [company] 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. [Emphases added]

The author went on to illustrate his point with an extreme example of a stock that paid a very large special dividend and showed how its price dropped by an amount nearly identical to the dividend.

To my way of thinking, the author made a very narrow point that is technically true. But he also implied a much broader point that is far more important: That the effect of the price adjustment is permanent. This is a point that we have seen made repeatedly. The proponents of "dividend irrelevance" seem always to imply if not state outright that the ex-div price adjustment is permanently built into the price of the stock, and that therefore the dividend is irrelevant at best and harmful at worse, because it is both taxed and deprives the company of growth opportunities.

I believe that even though this point is presented as obvious fact, it is in fact merely a thesis; the thesis is wrong; and that therefore the thesis itself is the actual "false god."

Let's first be clear about the price adjustment. It is an action taken by the stock exchange, not by market participants and of course not by the company itself.

In the NYSE Listed Company Manual, Rule 703.02 (part 2) states the following:

Normally, a distribution of less than 25 % is traded "ex" (without the distribution) on and after the second business day prior to the record date. This procedure is based on the Exchange's three-day delivery rule, pursuant to which contracts made on the Exchange for the purchase and sale of securities are settled by delivery on the third business day after the contract is made….In calculating the ex-dividend date, days on which the Exchange or the banks, transfer agencies and depositories for securities in New York State are closed are not counted as business days.

The rule includes a table showing the relation between record dates and ex-dividend dates according to the days of the week, as well as the impact of non-business days such as weekends and holidays on the designation of the ex-dividend date.

One important thing to note here is that the price adjustment is purely a creature of the exchange itself. As an aside, one may wonder why exchanges feel the need to interfere with normal market activity and make these adjustments at all. Presumably, if market participants in an "efficient market" feel the need to adjust the stock's price because it pays a dividend, they would do so themselves.

Does the price adjustment remain permanently in the price of the stock? Here is a chart of Johnson & Johnson (NYSE:JNJ) over the past two years. There have been eight dividends paid in that time. Can you spot when they were paid? Remember, for each of these dividends, the NYSE adjusted the price of the stock downward by the amount of the dividend.

(Click to enlarge)

Having trouble identifying when the dividends were paid? Here, this will help.

(Click to enlarge)

I don't see any evidence that the ex-div price adjustments had any lasting effect on the price of the stock. That would be because market participants set the price of the stock based on a multitude of factors, only one of which is the dividend.

In a recent article, Chuck Carnevale postulated that the market sets prices primarily based on earnings and does not much care whether some of those earnings are distributed as dividends or not.

With all things being equal, dividend paying common stocks provide their shareholders a return bonus, or what some might like to call a kicker, over an equivalent common stock that pays no dividend….[T]he stock market capitalizes earnings whether a company pays a dividend or not. Moreover, we contend that the market will value a given company's earnings based on their past and future prospects for growth, again, regardless of whether a dividend is paid or not…. If you examine two companies with equivalent rates of earnings growth, where one pays a dividend and the other does not, the dividend payer will provide their shareholders a higher total return.

In his usual thorough fashion, Chuck provided detailed portrayals of five companies - both dividend payers and non-payers - to illustrate and support his thesis.

There is one other point I would like to address here. In the original "false god" article, the author stated 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." [Emphases added.]

This is an extension of the narrow technical point that the exchange adjusts the price of the stock downward on the ex-dividend date. It implies both (1) that the price adjustment becomes permanently built in to the stock's price, and also (2) that in "giving away" some of its earnings, the company has deprived itself not only of value but inevitably of price equal to the dividend.

The choice of the phrase "gives away" is interesting. Of course, the money belongs to the shareholders who own the company. In distributing a dividend, the company is sending some of its profits to its owners. It is not "giving away" anything.

"The stock price has to drop." I beg to differ. As stated earlier, the stock price is determined by market participants based on many factors. With or without the artificial price adjustment by the exchange, there would be absolutely no necessity that the price has to drop on account of the dividend. There is no question that the book value of the company drops at the moment the company transfers the dividend to its shareholders. But to extend that to a perceived necessity that the market price must drop is merely another hypothesis, unsupported by empirical evidence as far as I can see.

Disclosure: I am long JNJ. 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.