Too many novice investors are not familiar with the dividend irrelevance theory. This theory arises out of work done back in the 1960s by Franco Modigliani and Merton Miller. There was even a Nobel Prize won for this and related work. I guess you don’t have to believe in this theory (even though I think you should), but it seems silly not to understand it if you’re interested enough in finance to be reading this blog.
What Is the Dividend Irrelevance Theory?
The theory is that the dividend of a particular corporation should have little, if anything, to do with its stock price. A company’s ability to earn profit and grow those profits is what determines its value, not its dividend payments. Investors are no better off owning a company that pays dividends than one that does not. Given tax laws, they might be better off owning companies that DO NOT pay dividends.
What Are Competing Theories?
Perhaps the most significant competing theory is one that is sometimes called the Bird In The Hand Theory. The idea here, one propounded by so-called “dividend investors,” is that investors prefer to get cash in hand, a dividend, rather than just having the value of their shares increase. Arguments for this theory vary, but they usually sound something like, “Management can lie about profits, but it can’t lie about dividends.”
Sometimes arguments are made that dividend-paying stocks have higher returns than non-dividend-paying stocks, and there is some truth to that. But not for the reasons most people think. For some dumb reason, some people also mistakenly think they can only spend income in retirement, and so they give unnatural preference to investments that provide income.
Taxes can also come into play. If tax rates on dividends were dramatically lower than tax rates on capital gains in a particular country or state, dividends would make a lot more sense than they do under our current tax scheme.
A better argument is that when a dividend is paid, management is saying, “We think you have a better use for this money than we do.” I actually like this argument because that’s how I run my own business. When I want to invest in my business, I keep earnings in the business. Theoretically, I can get a very good return on that reinvestment, or I wouldn’t do it. When the business generates more cash than I know what to do with, I pull it out and invest it elsewhere. However, I am skeptical that most publicly traded company CEOs are doing this the same way small business people do.
Maybe they are, though. Maybe that’s why companies often change over time from growthy, non-dividend-paying companies to valuey, dividend-paying companies. However, none of that changes the fact that earnings are earnings, whether paid out to the owner or reinvested in the company.
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A Dividend Is Not Dessert
Some novice investors mistakenly think a dividend is the financial equivalent of a free dessert. You had dinner with a stock price increase, and now you’re having dessert with the dividend. Sorry, that’s now how the accounting works. Just boil a corporation down to its essential elements, and you’ll see why.
Let’s say you own an entire company. At the end of the year, the company has made $500,000 in profit. As the business owner, you can leave that $500,000 in the business, or you can take it out of the business and call it a dividend, or anything in between. You can either own a business that is now worth $500,000 more, or you can own the business plus $500,000 in cash. Same, same.
Why Do Dividend Stocks Outperform?
While this hasn’t been true for a while, data over the long term shows that stocks that pay dividends DO have higher long-term returns. However, this isn’t because they pay dividends. It’s because they’re value stocks. That means you’re spending less to buy a dollar of earnings than you otherwise would be. A growth stock is like Apple. Everybody knows it’s a great company, and it often grows quickly. The investor is willing to pay more for a dollar of earnings because it thinks the earnings will grow faster. It’s sexy to own and sexy to work for.
A value stock is like Procter & Gamble. It’s not sexy. The company makes diapers and laundry detergent. Nobody grows up and says, “I want to work for Procter & Gamble.” And Procter & Gamble is actually pretty growthy compared to most value stocks. Its PE ratio is 22.4. (Apple’s is 34). The Vanguard Value Index Fund PE ratio is about 20 right now. British Petroleum has a PE ratio of about 12. So you can pay $12 for a dollar of earnings with BP or $34 for a dollar of earnings with Apple.
Not over the last 10-20 years, but over the very long term, value stocks have outperformed growth stocks. That’s probably because they are riskier. They’re more likely to go out of business. They’re also not sexy. Nobody can brag about them at a cocktail party, and it turns out that’s actually an important factor for some deluded investors. Value stocks are much more likely to pay a dividend at all and to have a high dividend yield compared to a growth stock. So, most “dividend stocks” are value stocks. But dividend yield is not really the best way to select value stocks. Price-to-book ratio and other financial valuation numbers are much better.
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Tax Implications
Dividends are actually really dumb tax-wise. In the US, we pay the same tax rates on dividends that we pay on capital gains. However, we get to control when we realize capital gains. The company gets to decide when it issues a dividend. If you wanted to keep your taxes low, you’d prefer to only have investment income when you want to spend it, like during retirement years, rather than during your earnings years. All else being equal, you’re better off “declaring your own dividend” by selling some shares than you are having the company send you a dividend when it wants.
Another tax benefit of declaring your own dividend is that the entire dividend is taxable, but that’s not the case when you sell shares. Some of that share price is “basis”, i.e., money you paid for the stock. Basis isn’t taxable. If you sell $100,000 worth of shares and the basis is $40,000, you only pay taxes on $60,000 of capital gains. That reduces your tax bill by 40% compared to the dividend model. But wait, there’s more. You can CHOOSE which shares you sell. Maybe you choose to sell the shares you just bought 18 months ago. The basis of those shares is $90,000. Now, you get to spend $100,000 but only have to pay tax on $10,000. Awesome!
But wait, there’s more. When you die, your heirs get a step up in basis. If they sell $100,000 worth of shares the week you die and their basis is $100,000, they pay NOTHING in taxes. That’s way better than getting a dividend. Same thing if you give stocks to charity. Let’s say you invest $100,000 for charity. It pays you big dividends every year. You pay taxes on those dividends and then reinvest what’s left in more shares of stock. Eventually, you give the shares to charity. But if the company had never paid dividends, you would have saved a whole bunch of money in taxes, and the charity would have received much more benefit.
The Bottom Line
Dividends are not a good thing. They’re irrelevant. Before tax. And after tax, they’re generally a bad thing. You need to understand this as an investor so you can make proper financial decisions.
Do you believe in the dividend irrelevance theory? Do you like getting dividends? Why or why not?
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