I am sure that the people on r/stocks are not the average investor, people on here go above and beyond the average person, taking investing from something most people do not think about, to something we spend our leisure time discussing. Hence, why I am making this post. I see all too often, both on YouTube and on various investing subs, the misrepresentation of dividends due to a lack of understanding what a dividend is. In this post I will provide the basic fundamentals of what dividends are, along with my own opinion regarding the misstatements I see.
Since this is the internet, I feel the need to clarify that when I say dividends, I do mean cash dividends.
To begin this post let me first ask you, what is stock? When you purchase shares of a company, you are purchasing a small piece of that company, thus making you a shareholder, or a small owner in the business.
Now what is a dividend and where does it come from? When a company decides to declare a dividend, on the declaration date a liability account called “Dividends Payable,” is opened up. Conversely, on the payment date, the account is paid out to the shareholders (aka you and everyone else). So you might be asking yourself, “ok, where does the cash come from, and why do I care?” Well, this cash comes from the retained earnings (part of stockholder's equity) and cash on the balance sheet. For those that do not know, retained earnings is the equity generated by net income. This is the money that can be reinvested back into the company, buybacks, distributed to shareholders via dividends, etc.
Example: A company declares a $50 dividend; it would look something like this:
Cash (-50)
Retained Earnings (-50)
I think it is also important to note that dividends do not impact the income statement. Yes, dividends are an expense, but they are not expenses that are tied to operations nor the generation of revenues. For this reason, voluntary distributions, such as dividends, are removed from the retained earnings.
Ok, understand I probably just put you to sleep, but hopefully you are thinking, “why are you typing all this?” I typed all this to explain that the money you receive is not free money. The cash you receive in your brokerage account does not manifest itself from nothing, but rather it came from the company's retained earnings.
The next question I want you to ask yourself is: “If you had $100 in your pocket, and you spent $10. Do you still have $100 of value in your pocket?” (Yes, I am aware this is a simplification, but feel free to add multiples, and complicate it if you please. So long as $1=$1, my math rings true.)
The answer should be a resounding, “no.” This is true for companies as well. On the ex-date of the dividend, the share price drops by the value of the dividend. This is a fact. In fact, this phenomenon occurs 100% of the time without failure. “Why?” you might be asking yourself. Well, the investor you sell your share to is not entitled to that dividend, and the company has made a commitment to disperse that cash off its balance sheet to the owner of the share. So why would someone pay more for less? They don't.
Now let's look at if dividends are always good. For this section I would highly encourage you to read: Warren Buffett's 2012 Letter to Shareholders; pp. 20-21. This is because it is basically what I would have typed out myself. So rather than listening to some random person on the internet, you can read the words/logic of Buffett and debate against him. The short answer is no, dividends are not always the best choice for a company, but sometimes in certain cases it can be.
To finally end this post, let's me share my opinion on dividend irrelevancy, arguably the most divisive topic on the investing subs of Reddit. First let me explain what this theory is, because I see many of its deniers misrepresent it. The irrelevance of dividends explains that an investor should have no preference between cash received from a dividend versus cash received from selling shares. It is NOT saying that dividends are not important to overall returns, and it is NOT saying that companies should not pay dividends. In short, a dividend does not add value to the company.
I am a firm believer of this theory, hopefully as you read my post you can understand why that is. First and most importantly, a company cannot remove value without losing value (aka, money cannot be created out of air), and that value is lost on the ex-date without fail. The only way for the company to maintain its current valuation, while simultaneously shrinking shareholder's equity is to change how that company is valued. I do acknowledge that most cases the dividends relative to the share prices are so small that it can go unnoticed due to the stocks volatility, however this does not mean the occurrence does not happen. If you would like an obvious example, turn to special dividends. On 11/16/2020, Costco declared a special dividend of $10 per share. On 11/30/2020, COST closed on $391.77/share, and on 12/1/2020 (the ex-date), COST opened at $384.50/share. (Not exactly $10 because of volatility but you can see the drop due to the $10 dividend) Furthermore, I will follow-up with the classic example to illustrate why investors should remain irrelevant to cash from a dividend versus cash from selling shares.
Suppose we have two companies both valued exactly the same at $100,000, both companies have the same growth, cashflows, etc. The only difference being that company Y pays a $1 dividend per share. Shares of company X and Y are both $10 a share, and you own 100 shares.
With company X, we decide to sell 10 shares, and in return we receive $100 cash. This leaves us with $100 cash, and $900 still invested in company X.
With company Y, on the ex-date, their stock falls to $9/share and later we are paid $100 in dividends. We are left with $100 cash and $900 still invested in company Y.
Now, this is where many people claim company Y has the advantage because you did not have to sell shares. Well, the best way to measure your returns is the overall value of your position, not through the number of shares you own, and I will illustrate that for you below. The only benefit of company Y is you own a higher percentage of company Y after the transaction. However, since you just read Buffett's letter to shareholders, you know why that is not always the best option.
(100 shares x $9/share) = (90 shares x $10/share)
Now some positives words about dividends. I do like that dividends keep people interested and excited about investing, if this is you, then keep on investing! But realize the truth about dividends; it is not free money. Yes, reinvesting your dividends does increase returns, same if you sold 3% of your portfolio every year and did not reinvest the cash, you would experience a reduction in your returns too.
The obligatory “not financial advice footnote”: This post is not financial advice, and should not be taken as such. I am just a random dude on the internet and encourage you to do your own research, and form your own opinions.
Leave a Reply