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  • Writer's pictureStephen Boatman

Are Dividends Irrelevant?

Updated: May 24

Dividends have an almost cult-like following. Believers shout their praises from the rooftops. However, is there a firm foundation under this strategy of basing investment decisions around stocks that pay dividends? We'll get into some of the cognitive bias, math, and research on dividend-paying stocks below.


Comfort Bias

Dividends are attractive because they inherently feel good. They take away the decision-making of having to sell something to receive cash. Due to this good feeling/security they provide they tend to be over valued, especially in uncertain economic waters. Most of my clients in the past have enjoyed dividends because, to them, it FELT like free money. But is it? Is a dividend simply a bonus on top of your appreciation or a hedge against falling stock prices?


The Math Behind Dividends

Let's use a simple example. If you currently own stock in a company that is worth $1 million. The $1 million valuation came from a compilation of future growth expectations, current inventory, buildings, real estate, brand name, and cash in the bank. The easiest of these valuations to peg a number to is the cash in the bank. If that number increased by $100,000, your company would be worth $1.1 million. If it dropped by $100,000, your company would be worth $900k, so if your $1 million company decides to pay a dividend of $100 to each of its 1,000 shareholders. Then they pay $100,000, and the company value will drop to $900,000. Each shareholder used to have a share of stock worth $1,000 = $1 mil/1,000. However, after the dividend, they now have a share of stock worth $900 and a cash dividend worth $100. They are no richer or poorer because of the dividend, but you, as a company, forced a sale of 10% of their stock to pay them this dividend. This is precisely what happens in the real world. If Walmart pays a 2% dividend, its share price will drop precisely by the dividend amount. This is harder to see in real life because the underlying stock prices are constantly moving, but if you believe in math then this has to happen. This shows that a dividend is more of a forced liquidation of a small portion of your stock holding and not a bonus/free cash payout that comes out of thin air.


Tax Inefficiency of Dividends

If we compare companies with the same profitability, growth rate, and overall expected return. The only difference is that one pays a dividend, and the other does not; I would prefer to own the stock of the company that doesn't pay a dividend. This is because of the tax inefficiency of dividends. With a dividend-paying stock, you have no say over when that dividend is paid, and your tax situation is not a blip on the company's radar when they decide how much to pay their shareholders. Where a stock that doesn't pay a dividend gives you complete control over when to receive cash via selling shares, or you could gift the shares to a charity to avoid taxes entirely or hold them until an inheritor gets them with a full step-up in basis! You could also have a low-income year and sell these shares at a 0% tax rate. These are all options dividend-paying stocks are not as good at because they force the "stock sale" via dividend, regardless of what's best for you.


Dividends Don't Account for Cost Basis/Purchase Price

If you need $10,000 in income from your portfolio for the year and your options are to either receive this income from dividends or sell shares, there's a difference in your tax bill based on where this money comes from. We will assume long term capital gains at the 15% tax bracket; and your $10,000 of dividends are qualified dividends taxed at capital gains rates and not unqualified dividends taxed at your income rate. In this example, the entire $10,000 in dividends will be taxed at 15%, causing a $1,500 tax bill. If you sell the stock, you have a basis (purchase price) to offset this tax liability. So, if the stock had a 50% gain, you would only be taxed at 15% on $5,000, even though you sold $10,000. Giving you a tax burden of $750 vs. the dividend options tax burden of $1,500 for the same $10,000 for the year.


Dividends


Do Dividend Stocks Outperform?

Dividend growth stocks do tend to outperform the market, but it isn't because of their dividend. It's often because they have exposure to other factors that are likely to outperform. Most companies that pay dividends are profitable, have stable stock prices, good cash flow, and are in a conservative industry. These are the factors that are worth pursuing; the dividend itself is more of a distraction. This means you will likely have a better chance of outperforming the stock market and dividend-paying stocks if you focus on the factors within companies with a higher chance of outperforming instead of targeting dividend-paying stocks. Because the dividend factor itself isn't a sign of outperformance and if you solely focused on that factor you would pass up other companies with even better exposure to other, more important, stock factors. I've written more about these factors (size, value, profitability, momentum, and asset growth) HERE.


Conclusion

I am not saying dividend stocks are bad or should be avoided; I'm saying there isn't enough historical data to persuade me to target stocks simply because they pay dividends. There are other specific factors I'd rather target because, on average, targeting the factors in the 5-factor Fama and French model have a better chance of outperforming the market vs. targeting dividends as a factor.


Financial Articles that helped inform this paper



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