Why I like Dividends
Cash in your pocket is better than almost anything else
I really like dividends.
Surprising statement, I know but it’s true.
There’s very little I like more than to see that my brokerage account has received a dividend, and that its balance is now a few dollars higher than it used to be.
Taking a quick browse at the upcoming dividends that I’m entitled to, that is, the ones whose ex-dividend date has passed, but the payment date has not yet arrived, is also an interesting and fun pastime.
Let’s talk about that.
What are Dividends?
A lot of people seem to be under quite severe misconceptions as to what dividends are, where they come from, and their role when it comes to shareholder returns.
So what are dividends?
According to Investopedia, a dividend is:
A dividend is the distribution of a company's earnings to its shareholders and is determined by the company's board of directors. Dividends are often distributed quarterly and may be paid out as cash or in the form of reinvestment in additional stock.
The dividend yield is the dividend per share and is expressed as dividend/price as a percentage of a company's share price, such as 2.5%.
In other words, a dividend is cash that is paid out to shareholders out of the companies earnings.
When you divide that cash payout by the current stock price, you get the companies dividend yield.
For some reason, people, even those who should know better, keep confusing things about dividends!
So let’s clear up some misconceptions:
Dividends come out of a companies stock price
This is a common theme even among educated people, and is a cornerstone of the “Dividend Irrelevancy Theory”.
I’ve already gone into the Dividend Irrelevancy Theory before, so have a read if you’re interested.
First things first, no the dividend that hits your bank account does not come out of the companies stock price.
There is no mechanism that transforms the market value of your stock into cash in your bank account via a dividend.
This idea is quite frankly stupid on the face of it, and people should know better, unfortunately they don’t and we get situations where even people with Series 7 licenses are spewing this kind of misinformation.
I’m not kidding about that Series 7 thing either, I’ve literally had arguments before with people with that license where they outright stated that the cash that enters a shareholders bank account does not come from the companies bank accounts, and instead comes from the stock price.
He didn’t elaborate on the mechanism through which that would happen. Probably because he’s an idiot that should go back to school.
Let’s be clear here:
The cash that enters shareholders bank accounts via a dividend is coming from the bank accounts of the company that issued the dividend.
That’s it.
It’s not complicated, it’s a straight up transfer of cash from the companies accounts into yours.
Now that transfer does often result in a lower stock price, and that’s often justified by one or more of the following reasons:
The company now has less cash so of course it’s current net worth is less
The company is intrinsically worth the sum of all its payouts, and now it has one less payout to give
Now, these reasons do seem legitimate on its face!
And to some extent they are right!
But it’s important to note that companies generally don’t trade at their book value, hence the effect from 1 should be proportionaly lower than the cash value of the dividend!
Additionally point 2, while accurate, ignores the benefits of actually paying the dividend in not just finally getting the cash in the hands of shareholders, but also in preventing the management team from wasting it, and in removing the uncertainty of the payouts from the “stock price”.
Paying a dividend in itself is an indication that future dividends might come, and so that in itself provides additional certainty in regards to returns, which reducces risks and subsequently the risk related portion of the discount rate.
A more reliable argument I would say is the knowledge that there are investors conducting dividend harvesting strategies, which cause these fluctuations of prices around and before the ex-dividend date.
A company pays dividends according to its yield
This is again, similar to the idea that the dividend payment comes from the stock price.
At its core the argument is flawed because you’re looking at it the other way around.
The dividend yield is calculated based on the paid dividend, not based on some yield dictated from on high!
While it’s true that some companies have historically used some target yield in order to determine the payout, it’s important to note the following:
This was a long time ago, and has long since been phased out
It only happened in some companies, in some countries
It only happened due to cultural/historical reasons in order to provide investors a way to compare with fixed-income investments
Ultimately the companies ability to pay the dividend continued to rely on its earnings.
A high dividend yield tells you nothing about the companies earnings, or its ability to pay the dividend, nor does it tell you anything about its ability to grow its business, or to reinvest in itself.
In a way, a high or low dividend yield is more of a reflection of the markets enthusiasm for a given company, than it is about the company itself!
That’s not to mean you should ignore it entirely! But it also means that what you really need to be looking at is the companies ability to continue producing earnings, and whether or not those earnings will be sufficient to make good on its commitments, including its dividend payments!
If that is the case, then you should be able to arrive at a given valuation for the company, and from there decide whether to invest or not.
What about you?
Do you like dividends? What was the last one you receive?
Let me know in the comments below!