I see a lot of focus on dividends among new investors on Freetrade. While dividends are great I wanted to make a thread covering why it makes no sense to focus on dividends when making investment decisions (unless the company’s dividend policy is negatively impacting growth/unsustainable). Hopefully this can be helpful point of reference.
This is referred to as Dividend Irrelevance
There is a Freetrade thread on a video by Ben Felix that very neatly explains this, if you don’t want to read a load of text just watch that video, it explains this.
Why would a company pay a dividend?
If a company has cash that they can’t generate a good return on, they are destroying shareholder value by holding on to it. This is because investors could use that capital to invest elsewhere and expect market returns. This could happen if there are no viable ways for the company to invest in future growth (either internally or through acquisition of other companies)
For this reason sometimes a company chooses to distribute cash to investors. They do this in one of two ways; either issuing a dividend or buying back shares. A dividend moves the cash from the company’s balance sheet into the hands of investors . A share buyback moves the cash from the company’s balance sheet into the value of shares held by investors (by reducing the number of outstanding shares).
It seems obvious, but for clarity: this process does not create money out of thin air, it just moves it. From the investor’s perspective distribution has no immediate impact on value (tax implications aside).
There is an worked example of the impact of dividends on total returns in Buffet’s 2012 letter to shareholders (starting page 19)
So far it may seem like dividends and buybacks are identical, however they are taxed in different ways which might be relevant to investors. Dividends will be subject to dividend taxes while increases in share value will be subject to capital gains (when sold).
Investors can choose when to sell shares, however they don’t have direct control over a company’s dividend policy and as such this may have sub-optimal tax implications.
This means dividends can have a negative impact on total returns as described in this FT article
Despite their irrelevance some investors do look at dividends as a proxy for earnings / quality. For this reason lots of companies will pay out dividends even when they don’t have excess cash in order to be seen as a consistent dividend payer.
This can be problematic because at a time when the company may already be struggling with reduced earnings if they decide to maintain dividend payments then they have to choose to reduce investment (and consequently future growth) or take on debt to fund the dividend or both.
A firm’s payout ratio gives information about what fraction of the earnings are being paid out, if this is over 100% then the company is paying out more in dividends than it is earning at that time.
Also some companys do become shackled to their dividend policy, paying out dividends even when it doesn’t make sense to do so (no surplus cash) at the expense of future growth, reducing total returns for investors.
Dividend stocks out-performance
Some people point to consistent dividend paying stocks outperforming the market as a reason to pick them. This out-performance is better attributed to value/quality factors (e.g. p/e or stable year on year earnings growth) rather than the market irrationally undervaluing dividend paying stocks.
Dividends as a stable income source
Some people suggest the reason to pick a dividend paying stock over a non-dividend payer is that it provides a stable source of income. While this is true to some extent dividend payments do still vary quite a lot and are determined by the company’s policy, this may lead to insufficient or excessive payments for investors.
As selling shares gives the same result as a dividend payment and is entirely at the investors discretion this is a more reliable way of taking income. You get to choose exactly how much to withdraw and when.
This is sometimes referred to as homemade dividends.
- Don’t choose investments based on their dividend policy unless there are specific tax reasons to do so.
- Ultimately earnings determine how much cash a company is able to distribute, how they choose to distribute excess cash (dividends / buybacks) is largely irrelevant.
- Don’t reduce your diversification by excluding non-dividend paying stocks
- Do your own research. If you care about earnings - look at earnings directly, don’t use dividends as a proxy for profitability
- Avoid dividend payers if there are tax reasons to do so or if the company’s dividend policy is having a detrimental impact on long term expected returns.
- Consider looking at dividends if your dividend tax rate is considerably lower than capital gains (as this might help reduce total tax)
- Don’t be constrained by a company’s dividend policy, if you wouldn’t sell shares then reinvest the dividend. If you wanted a dividend (income) and weren’t paid one - then sell some shares to create it yourself.
Resources (I’ll expand this if I find anything else that helps explain this)