When Dividends Are Irrelevant
You might think I am out of my mind, because the society has always preached about holding stocks for the long term to receive dividends that will become your passive income. Somehow the end goal is to have these dividends large enough to be your income strategy and voila, you can retire!
A disclaimer before we dive deeper into the dividends irrelevance theory: I do not mean dividends are unimportant to total returns, but what I am trying to convey is that dividends are irrelevant when determining which stocks have good future returns.
The research for this theory started back in 1961 by Merton Miller and Franco Modigliani. They explained that investors should be indifferent between receiving a $1 dividend (which will cause the stock price to fall by $1) vs receiving $1 by selling the shares. The fact is that $1 must equal to $1.
Say for example we have Company A that pays dividend and Company B do not, and you own 1000 shares worth $10,000 in each Company A and B, and are both valued at $10 per share. We are holding the assumption here that these two companies are exactly the same, i.e. the same size, profitability and price to book value. Now say Company A pays a dividend of $1, you would have received $1000 in dividends, and your shares are now worth $11 each. Company A now makes up $11,000 of your share portfolio and $1000 in cash. Company B pays no dividend but under the same assumptions, the share price for Company B should be valued at $12 each. Company B should make up $12,000 of your portfolio.
Mathematical wise, this has to be true. A dividend is a cash payment from the company and the value of the company falls by the amount of dividends. That is why prices for shares always fall after the ex-dividend date. To me, receiving a dividend is exactly the same as selling off some shares, by way of creating ‘homemade’ dividends. Dividends in no way guarantee future returns. It also limits your stock picks as roughly half the global stocks do not pay dividends and even companies that pay dividends are usually large cap stocks.
The toll here for considerations would be timing, taxes and brokerage.
You do not get to decide the timing on receiving dividends, but you don’t have to pay for brokerage fees when receiving one. On the other hand you get to sell according to your own timeline, but will have to pay for brokerage when cashing out. In Australia, dividends can come with or without franking credits, which may or may not be beneficial to your tax rate depending on your other taxable income. Capital gains on the other hand will have a 50% discount if you hold the shares for more than a year.
With those taken into considerations, do you still prefer to go after income investing?
