Exactly whats happened during COVID - many dividend paying companies stopped paying dividends, some temporary, some for an unspecified period. In the UK banks were forced to stop paying dividends, and other companies took the (prudent) path of holding onto their cash in-case its needed to sustain the company.
Good piece Cameron, this is something I have been giving a lot of thought to recently just to add my own two cents worth.
I think the fact that the theory is called âdividend irrelevanceâ or the rather combative stance Ben Felix takes in his video unfortunately acts as a distraction from the debate. The questions that I think are more important are âat what stage is a company in its life cycleâ and âwhy is it paying a dividendâ when you take a look as to what is actually going on inside a company
The life cycle of a company
Start-up/pre profitability: Early life
In the early stages, companies tend not to make any money at all, they burn cash and need a constant supply of new capital to fuel revenue growth. The reason they can consistently tap funding in the form of equity offerings or debt is that their growth narrative and track record is strong enough to justify a short term hit. (this is basically where freetrade is now, think of the majority of companies you see on crowdcube or companies like uber)
It is completely ludicrous for companies to pay a dividend at this point as they arenât making any money, it would just mean they then need to raise more investment capital at each new funding round. Instead they retain everything and invest in things to continue to grow in order to become profitable at some point in the future.
Cash flow positive, still growing rapidly
If the company succeeds in building enough scale and monitisation it will become profitable, but the amount of profit is very low compared to the market value of the company. This is typically because the amount of profits in absolute terms are small, profits and revenues are growing rapidly year over year and the net margin from sales is typically low. This are your typical âgrowth stocksâ that have sky high P/E ratios that make value investors want to cry.
Again it doesnât make much sense to pay a dividend at this stage although some companies do, the company potentially has a long road of growth in front of it and it should be maximising every opportunity to do this. Sometimes the companies are still tapping capital market to issue new shares or to borrow more money to grow the business.
Typically as well, the return on capital (the return in earnings on new capital invested in the business) is very high, so investors are getting a better return by allowing the company to retain the profits to grow. Its not uncommon to see companies in this stage to have a return on capital above 30% which is far better than I could reasonably expect to do if the money was paid out to me the investor instead.
To cite one example of a company like this, take a look at GYM.L, The gym group have been investing rapidly in opening 20 or so new low cost gyms every year, they have a high PE ratio (pre-covid) but profits grow handsomely each year.
I am an investor in GYM but one think that has always bothered me about it is that it pays a dividend, the divided is so small to make that much of a difference to my portfolio but they could have build another gym each year with the cost of that pay-out.
Growth slowing or flat
It isnât an absolute rule that companies reach this stage and if they continue to innovate they can get themselves back to rapid profit growth (companies like Microsoft and apple have been here before, IBM is here now and is struggling to get out), however most will reach this eventually.
Companies tend to start paying large dividend yields when they get to this stage, usually because they have no useful ideas as to what to do with all the profits they are making. They have reached a stage of saturation and growth is now very slow if perhaps even non existent. As a result the PE ratio has fallen to around 15 or less. If the company can come up with a compelling narrative as to why they should retain more and spend more on CAPEX then an argument can be made for a lower dividend so that investment and a return to growth can occur, although many companies cant make that justification so the profits are paid out to shareholders.
Shackled to a pay-out
Now what can be incredibly insidious about this stage is that there may be solid growth opportunities for company to grow again, but their dividend pay-out has them effectively shackled. When I look at companies like BT and IBM you can see companies that if they had more capital to play with could invest heavily in achieving this. But they still have to maintain the dividend which means they have a lot less and can become effectively paralysed (look at the rise of hyperoptic with fibre broadband rollout, a private company that has no need to pay a dividend).
Why is this the case, cant the CEO just make the decision to cut the dividend? Technically yes, in reality no. CEOs and chairmans are extremely reluctant to do this even if its in the long term interests of the company. because it causes the share price to crash. In the case of âdividend aristocratsâ would mean removal from many of these funds and ETFS. Donât forget that short term share price is quite often seen as the barometer of success or failure for a CEO at a company regardless of what is actually going on beneath the surface,
Essentially, when it comes to what the company is doing, which is a massive part of the investment case for a company, dividends are extremely relevant indeed. When it comes to the total return of your portfolio year over year its less so, they are just one facet of the return and you hope that you arenât investing in companies that are placing the value of their dividend pay-out over the long term interests of the company.
Why do you invest?
I am in my early thirties, I am not planning on accessing my investment pot for a long time yet and I want to maximise its growth, so for me dividends arenât that important, what is more important is trying to maximise my long term annualised return. However I donât think that is going to be the case forever and as I get closer towards a retirement age I may place a higher value on income as opposed to growth. Psychologically at that point it appeals to me to invest in an index, live off of the dividend income and leave the capital untouched so that I know I wont be eating into it over time, which just becomes a bit trickier when drawing down from the capital value of growth stocks.
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Thanks for adding this some very good points I didnât cover. A lot of your points are views I hold as well but I didnât want to over complicate or bias the OP, I was aiming for dividend-agnostic rather than anti-dividend.
I did allude to problematic dividends, but you are right to point out that even a sustainable dividend can reduce total return through opportunity cost. Maybe I would refine my assessment of dividends in that they should never be a reason to choose to invest in a company, but they could be a valid reason not to invest (if the company is shackled to it).
The logical reason to pay a dividend is to get rid of excessive cash, but looking at most of the companies paying them at the moment I donât see any rationale for doing so (beyond short term incentivisation). This strongly supports your theory that management is either unwilling or unable to cut them, despite the long-term negative consequences for shareholders.
As you can tell a key message Iâm trying to convey is that income investors neednât rely in dividends either, once you get over the psychological barrier all you need to do is focus on total return and then take control of distributing cash yourself.
If your total return is 6% it doesnât matter how much is dividend or growth, you can still safely draw down up to that amount without eating into your capital.
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Thanks for positing this Cameron! Iâm pretty sure I learnt this in Finance 101 (Modigliani & Miller - Dividend policy is irrelevant to company valuation) so it puzzles me why this isnât more widely understood!
Also, Freetradeâs fractional shares means you can sell a very small portion, just like a dividend 
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Dividend Irrelevance is a theory that presumes book value = market value. The value of the share after a dividend can recover incredibly quickly irregardless of book value and continue to grow very quickly, and this depends on a number of factors including future cash flow and investor sentiment towards the next dividend.
I dont agree with your point that dividends are not a better source of stable income than selling shares.
As book value does not equal market value the pandemic has driven a lot of my growth companies down despite them being stable finance wise and these can now only be sold at a loss and therefore should not be relied on for income, where as dividends continue to come in and have their price recover relatively quickly.
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Might interest some folks: Social Capital CEO Chamath Palihapitiyaâs case against stock buybacks, dividends
Thanks! Freetrade is opening up investing to a lot of new people, so while it might be fairly basic knowledge in some crowds I think itâs reasonable to expect a lot of people here arenât familiar,hence the thread. Itâs great that lots of people are helping out new investors on these forums as to be honest if you start googling from scratch you find a lot of misinformation.
Thatâs not true, I know the Ben Felix example uses the same price to book value ratio for simplicity, but it does not assume book value = market value.
I agree there can be irrational behaviour around these and often there are compounding factors - e.g. dividends coinciding with earnings / expectations that murky the response but I really donât think the long term investor should be banking on those trends.
Iâve tried to explain how these are functionally the same thing already. Iâm not saying that all companies behave the same way or that the total return of different stocks has been identical, just that the dividend policy isnât particularly relevant to that total return.
Of course investors should consider defensive strategies that will be more resilient to market downturns / sentiment (i.e. choosing more established blue chip mature companies vs young growth companies) just donât base those decisions on a dividend policy.
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I agree that you can have a successful income strategy without dividends and you shouldnât invest in a stock just because it pays a dividend. However for some companies I think dividends can be an important factor. For example if youâre investing in a company that you think is under valued thereâs no guarantee the share price will recover even if the underlying business continues to generate good profits. Whereas if they pay a dividend you can earn a good return regardless of the share price.
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Whilst I understand the theoretical value of the points you are making they do not really stand up to scrutiny when placed into the real world.
If I require income to live off and I am building a portfolio accordingly then I am going to weight to a company with a dividend policy over one without.
Having growth stocks is great when youâre in the accumulation phase because you can afford a bad year or two. However, if you need income then selling shares at a loss to achieve this is worse than just leaving money in a bank account. It is not âfunctionally the sameâ as a dividend. The way pricing modelling works a single dividend paid out barely impacts the price of the share because you are valuing all the dividends over a long-term period so the share price just readjusts based on expected growth, the discount rate etc. rather than dropping and never recovering.
This claim is wrong because for the theory to make sense you do have to assume book value = market value and leading proponents assume this. That is the whole basis for the theory. Then you assume a dividend decreases book value leading to a similar fall in market value. This then makes the method of cash flow realisation irrelevant. However, this just does not stack up when measured against stocks in the real world.
The payout of a dividend does see a proportionate fall in book value but that is not particularly relevant. Itâs not as if that stock falls by that value and never recovers because that cash is now off of the book value. Provided dividends are stable/growing and the discount rate is stable/falling (ideal is growing + falling) then share price will rise even after payouts.
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It really isnât and none of the resources I linked make that claim. For completeness Modigliani and Millerâs original assumptions are:
- Taxes do not exist: Personal income taxes or corporate income taxes
- When a company issues a stock, there are no flotation costs or transaction costs
- When a firm decides its capital budgeting, dividend policy has no impact on it
- Information is readily and freely available to all investors. Information about the firmâs future prospects is available to the companyâs manager as well as investors
- Leverage has zero impact on the cost of capital of the company
I accept itâs not perfect and Iâve even highlighted many of these in the original post (particularly taxes and capital budgeting).
Yes, if 2 companies differ only by the fact that one of them has an extra ÂŁ100m in cash almost anyoneâs valuation system is going to also differ by approximately ÂŁ100m. (Above assumption that leverage has zero impact on the cost of capital of the company is relevant here).
Are there some edge cases where dividends do make a difference? Yes, of course (and I list some) but that doesnât detract from the fact that most new investors need not factor dividend policy into their investment decisions. Others who already have the financial literacy to understand dividend irrelevance (and itâs limitations) anr probably probably making the relevant considerations, this thread will be of no value to them.
This thread is aimed at the âI decided to invest in BP as they consistently pay a good dividendâ or âwow look at the yield on this ETFâ crowd, not the âlooking for feedback on my DCF model for Appleâ types.
This phrasing suggests there is broad academic debate on the subject. Your emphasis of the word âtheoryâ (while correct) is reminiscent of the âtheory of evolutionâ crowd.
Iâm not here for a debate with people who deny dividend irrelevance broadly. Iâm happy to try flesh out points around the edge cases and try and explain concepts to anyone who doesnât understand, but if someone has read the resources and doesnât accept the core concept Iâm never going to change their mind and Iâm happy to just let it be.
I agree with having mainly Dividend paying stocks simply because I like to have something that gets paid into my account like a 2nd wage and I imagine at its core base, thats how many others think too.
I simply cant be bothered having to sell them, watch for price falls and rises etc all the time. I like to buy and leave them to do their thing, fire and forget. You can have all the findings to back up the concepts of what you have proposed and thats fine, its not without merit, but some people just like to buy and keep topping up a stock that will pay them each month, quarter etc without having to pretty much do anything.
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I think I largely agree with the theory from what youâve written but the word âirrelevanceâ seems a bit misleading to me. I think the important point is they arenât essential. I.e you donât need dividend stocks to get a stable income in the same way you donât need growth stocks to accumulate a significant amount of money.
In general I think itâs good to have a mix of dividend and non dividend stocks because dividend income is based on company policy and fundamentals whereas income from selling stocks is based on market sentiment. So a combination seems like an added layer of diversification.
If you take dividend yield on its own itâs a terrible indicator of what you should invest in but no metric is great if you take it on itâs own.
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Yeah to be clear the implications of dividend irrelevance arenât âdonât buy dividend paying stocksâ so I completely agree a diversified portfolio makes sense. The key thing is just donât worry about dividend policy when making investment decisions, which is where the âirrelevanceâ bit comes in.
I donât think that point quite goes far enough, because if you accepted they arenât essential you could still come to the conclusion that âdividend investingâ is a logical strategy, that sits alongside other strategies.
If I said investing with companies that start with the letter A is a valid strategy, but itâs not essential that still sounds ridiculous.
To take the above example, if I said that the first letter of a company is a terrible indicator on its own but when combined with other metrics itâs fine that will still sound crazy. You would just say, obviously the other metrics are what matters and the letter itself is irrelevant - thatâs the crux of this.
I see the point about not excluding stocks just because they donât pay a dividend (dividend investing strategy), that makes sense.
However I still think the dividend policy is useful information, in terms of both cash allocation (what the company does with its profits) and an income that is independent of market sentiment.
I just donât think this is a sensible or helpful approach for a novice investor, or indeed any investor, to take for both quantitative and qualitative reasons and not something which should be spread across this forum as if it is gospel truth.
The biggest single flaw with this argument is the way valuations work. When you receive a dividend, you realise cash flow but it does not reduce the intrinsic value of the company as your valuation calculations are forward looking. However, if you sell a portion of your shares (of an equal value to a hypothetical dividend) then your intrinsic value is reduced because you forfeit a portion of your future cash flow. Which means the argument that selling shares is the same as receiving a dividend is false.
From 1972 to 2018 dividend initiators and growers materially outperformed the S&P 500 with materially lower beta and so the evidence is largely against this theory.
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Anyone know a site which charts total return for UK stocks and ETFs ?
Iâm not going to attempt to explain the other points again, but I preempted this and addressed it in the OP.
You havenât explained those points at all? You have talked about the perfect theory of dividends reducing book value and two identical companies being worth different amounts depending on different amounts of cash on hand. Both are correct points but do not represent real scenarios in the market.
You also never actually refuted my claims about how selling shares means forgoing future cash flow but collecting dividends does not?
On the point about outperformance, you just stated that it is explained away by other things but itâs seems like an awfully weird coincidence that companyâs which pay and grow dividends have outperformed the broader market. Where is the proof that dividends did not assist in this outperformance?
Iâm not saying dividends explain it 100% but they clearly canât be âirrelevantâ. Dividends instil discipline and focus a management on cash flow. They prevent long-term egotistical bets wasting shareholder money. Dividends also aid in capital efficiency as companies have less cash with which to achieve their stated aims of growth forcing them to be more efficient and focusing on higher returning options. In order for âDividend Irrelevance Theoryâ to hold up you have to prove they arenât a factor.
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Compared with other equities, the performance of these strategies has been time-period dependent and largely explained by their exposure to a handful of equity factors: value
and lower volatility for high-dividend-yielding equities and lower volatility and quality for
dividend growth equities.
The strong historical risk-adjusted performance of dividend-oriented strategies has been time-perioddependent, with much of their outperformance realised during the technology stock bear market of 1999â2000. The performance of dividend-oriented strategies has also been highly dependent on a handful of equity factors. Emphasising these strategies therefore reflects, in effect, a conviction that these factors will continue to outperform.