- The Upside of Divdends
- The Downside of Dividends
- The Company is not able to reinvest its profits
- Dividends affect the Company’s Market Value
- Investors may fail to make objective decisions
- Increased Error in Forecasting
- Investors’ sentiment for dividends may influence the company’s dividend policy
- Dividends increases cost for investors
- Ignoring the fundamentals of the company
- Conclusion
As an owner of a company, you’re entitled to share any profits that the company makes! Dividend distributions are one of the ways companies share their earnings with their shareholders!
Some would say that additional cash is a good thing! But others might be more wary of dividends.
Well, we’ll start with what’s good first!
The Upside of Divdends
Ease of Valuation
Some would suggest that if a company has a history of constantly paying dividends, and has been increasing its dividend payout, that’s a decent gauge of a strong-performing company that is able to constantly pay its owners more!
Using the current dividend yield of the stock could also allow us to evaluate whether the stock is overvalued or undervalued! If the dividend yield is low, the stock may be overvalued and if the yield is high, it might be undervalued!
This is called the dividend-value strategy, crowned by Wright (2010), which not only uses the dividend history but also the dividend yield to evaluate whether the stock is a good buy!
Price Stability
Some have suggested that stocks that have a consistent dividend history are also observed to have more stability in their price! Well, at least for blue-chip stocks that have had stable performance over the years!
Positive Expected Future Earnings
Dividend distribution could also be hints of future earnings! An increase in dividend distribution can be a hint that the management expects better earnings performance in the near future!
Improves Trading Liquidity
Stocks that have a high, consistent dividend distribution would attract income-seeking investors! This would increase the number of participants willing to trade, increasing the stock’s liquidity!
Increase Personal Income
When a stock pays dividends, shareholders receive cash! That means additional income for them! It’s as simple as that!
Reduce Cost
If investors are seeking income, why not just sell part of their holdings? Transaction cost! Selling off a portion of their portfolio may not be feasible for all investors; for portfolios that may be smaller, transaction costs may remove a larger portion. There are no transaction costs on dividends received!
Having Control
The surest way that a company is not spending on bad investments or overpaying managers is if those earnings are returned back to their owners! Dividends are the surest way for shareholders (who are owners of the company) to ensure that the money flows back to them!
The Downside of Dividends
The Company is not able to reinvest its profits
Now for the downside, firms that are paying all, or most, of their earnings have no retained earnings to reinvest back into the company. This might result in less value creation and slower business development.
Dividends affect the Company’s Market Value
There are also others who suggest that dividends are at the expense of the share price. If you think about it, when a company announce a dividend distribution, the price of the stock would be adjusted accordingly on the ex-date and the outcome would be an increase in cash in the shareholder’s portfolio but a similar comparable reduction in the stock’s value!
Associating dividends as a source of free income, while ignoring the relationship between the stock’s price and the payout, is known as the Free Dividend Fallacy (see Hartzmark & Solomon, 2019)!
Investors may fail to make objective decisions
To expand on the Free Dividend Fallacy, if shareholders perceive price changes in their stock as independent of dividend payout when assessing their portfolio’s performance, they might conclude that a stock is underperforming just because it went down in price after they bought it.
For example, for a stock that went down to $8 after paying a $0.75 worth of dividend quarterly, investors who had bought it at $10 a year before might be unwilling to sell it because they may perceive it as a $2 loss, instead of a $1 gain (inclusive of the $3 worth of dividends received)!
Increased Error in Forecasting
Investors who forecast prices solely by looking at the company’s dividend history might be too optimistic in their pricing methodology.
If we were to solely use the Dividend Discount Model to determine whether a company’s share price is over or undervalued, we would be ignoring other factors, internal and external, that may affect the profitability of the firm!
Investors’ sentiment for dividends may influence the company’s dividend policy
Management may decide on a dividend policy that has the least impact on the stock price. Raising dividend payments too quickly may communicate a confident expectation of future earnings, driving the price up, and resulting in a lower yield! Decreasing the dividend payment amount may raise earnings concerns, decreasing investors’ confidence!
Dividends increases cost for investors
Under certain tax jurisdictions, dividends may leave investors worse off if they had just sold their shares. Depending on where the investor is and the tax jurisdictions that are applied to the investor, dividends may be taxed at the income level while they may be subjected to capital gains tax if they had sold their shares!
Foreign investors may also be taxed at a dividend withholding tax rate if there is no tax treaty between the two countries!
Ignoring the fundamentals of the company
Solely focusing on the dividend yield and dividend history to make investment decisions may not be the soundest of strategies, considering that there is a business behind the stock that you own!
A company that pays consistent dividends may not be able to keep up in a changing climate; a company that is currently trading at a high yield due to its share price’s tumbling might be because of fundamental flaws in its current business strategy. By solely looking at the dividend history and dividend yield, investors are restricting themselves from the whole story!
Conclusion
There’s no generic one-size-fits-all investment strategy and focusing on dividends alone may, or may not, get you there. Dividends are not evil nor are they saints. Dividends can offer additional income to investors, but it may be at the expense of the company’s growth. Dividend history tells a story about the company’s past, but it does not necessarily relay the whole picture, nor can it be used to accurately predict how the company might perform in the future.
References
Bräuer, K., Hackethal, A., & Hanspal, T. (2022). Consuming Dividends. The Review of Financial Studies, 35(10), 4802–4857.
Cahit Adaoglu, & Meziane Lasfer. (2011). Why Do Companies Pay Stock Dividends? The Case of Bonus Distributions in an Inflationary Environment: WHY DO COMPANIES PAY STOCK DIVIDENDS? Journal of Business Finance & Accounting, 38, 601–627.
Feldstein, M., & Green, J. (1983). Why Do Companies Pay Dividends? The American Economic Review, 73(1), 17–30.
HARTZMARK, S. M., & SOLOMON, D. H. (2019). The Dividend Disconnect. The Journal of Finance (New York), 74(5), 2153–2199.
Jiang, H., & Sun, Z. (2020). Reaching for dividends. Journal of Monetary Economics, 115, 321–338.
Miller, M. H., & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares. The Journal of Business (Chicago, Ill.), 34(4), 411–433.
Nguyen, A. H., Pham, C. D., Doan, N. T., Ta, T. T., Nguyen, H. T., & Truong, T. V. (2021). The effect of dividend payment on firm’s financial performance: An empirical study of Vietnam. Journal of Risk and Financial Management, 14(8), 1–11.
Wright, Kelley. (2010). Dividends still don’t lie the truth about investing in blue chip stocks and winning in the stock market (1st edition). Wiley.