Dividends are often touted as the way to make passive income with a share portfolio. After all, dividends are akin to the rent paid from an investment property, just with shares, right? Well…
Dividends & distributions are not free money
A very large misconception still exists within the world of investing. The idea is that receiving a dividend is some form of bonus for owning that particular stock. This is often touted in the media as seen in this headline:
This plays on the common misconception that dividends are an extra return on top of the growth you got in that stock within a given time period. This is fundamentally wrong for one reason alone:
The dividend you are being paid is simply a profit that the company has already made and declared to the market.
Ever notice how that on the day that any new buyers of the stock aren’t entitled to the dividend (the ex-dividend day) the stock price drops almost exactly the same amount as the value of the dividend?
This is because the cash that the company holds in order to pay out the dividend is already reflected in the price of the stock. Once the cash is gone, it’s worth less and therefore the stock price changes.
A good way to think about it is to imagine you have your own business where you are the sole shareholder. In one year, you make a profit of $100,000. The business doesn’t need the money so you decide you can pay out the whole amount to yourself as a dividend.
Now I ask you, did you just get $100,000 richer by transferring the money to yourself? No, of course not. Your business got $100,000 poorer and you personally got $100,000 richer (less tax). You didn’t create value out of thin air just by paying the dividend. This works the exact same way for any company you own a share of, either personally or via a managed/index fund.
A well-used analogy for dividends is that you’re simply moving money from one of your pockets to another.
So, are dividends good or bad?
It depends.
Dividends are taxable income, that’s the primary consideration. Now, in Australia we get franking credits. Simply put, this means that you get a tax credit for the tax that the company may have already paid, meaning it is not double taxed.
If instead that dividend you received was actually maintained in the company as share price growth, this would more than likely be better from a tax perspective. This is because if you ended up selling some shares for whatever reason, tax would only be payable on 50% of the growth (assuming held for >12 months) due the CGT discount. Just keep in mind that generally you are taxed lower on capital gains than you are on dividends.
The downside for dividends is obviously tax, but it’s also removing working capital from the business. This means it doesn’t reinvest those earnings into other areas of the business in order to increase the value of the company even further. This isn’t necessarily a bad thing, but it needs to be considered.
The quintessential company that doesn’t pay a single dividend and instead directs all earnings to reinvestment, is Warren Buffett’s Berkshire Hathaway seen here:
Now, some would contend that the cash from earnings is probably better used by Buffett than it is by another other investor. Is it the same for all other companies in every other industry? No. But it is worth it to remember that every dollar in dividends you receive is a dollar that the company isn’t using to reinvest or buy back their own stock.
The primary takeaway is that it doesn’t make sense to base an investment strategy solely on receiving dividends. Will good companies still pay dividends? Yes. But are there great companies out there that pay little to no dividends? Also yes. It would be pretty silly to miss out on these amazing companies simply because they choose to reinvest their earnings or buy back their own shares.
The difference between a share’s dividend and say a rental payment on an investment property is that when your tenant pays rent, it does not decrease the value of that property.
Dividend Yield
Please do not fall into the trap of looking at previous dividend yields on the internet and think that is the percentage you will get into the future. Dividend yield is calculated by dividing the amount of dividends paid in the last 12 months by the current share price.
So, a company with a $100 share price today with $5 worth of dividends paid in the last year will have a dividend yield of 5%.
What happens if that share price drops suddenly and now it’s worth only $50? Again, divide the new share price by the same $5 of dividends. We now get a dividend yield of 10%.
Great investment opportunity, right? Hopefully it’s very obvious to why that isn’t the case.
Dividend yield is a not a very good metric to determine future dividend potential (and as we previously found, higher might not be better).
