Are dividends an actual gain value?

Question

Dividends from stock or funds are obviously considered to be an earnings benefit or a gain or a plus, but I'm wondering how that is monetarily computed? I know it is added to the gain income, but I mean, what is the rationale for that?

The company (or the companies in a fund) pay the dividend out of their cash reserves. But it is no gift in the market, because the stock or fund price and value immediately drops by an equal amount. So it is clearly only the same effect as any normal withdrawal. It was my own fund money returned either way. Tax is owed either way, except the dividend has a zero cost basis, and a withdrawal likely has some cost basis (reducing tax on the withdrawn amount). What am I missing? Why invent dividends? How is that a gain?

When my bank pays monthly interest (such as it is), my deposit increases by the amount instead of decreasing by the amount. That is a major difference. There must be an assumption that stock dividend expectation has slightly increased the sale price, actually increasing fund value first, but I don't see how it could be proved.

The only plus that I can imagine is that when and if the dividend is reinvested, the value of the increased shares at the lower price remains exactly the same (no advantage, no actual income change yet). The increased cost basis more or less offsets the necessary tax paid, but only at some time in the future. However, since the reinvestment is a purchase that does buy a slightly higher share count, of still the same value, more shares in the fund could earn a little greater gain in the future. I see no way to quantify that, but I'd suppose a 2% dividend, if reinvested, is 2% more shares and a higher cost basis (compared to if no transaction had occurred at all). Is that the whole story of dividends?

I have no experience with bond funds, do they act the same or not? If actual paper bonds are owned until redemption, their redeemed price can't change because of any dividend (and then interest was actual income). But bond funds may not be able to hold them until maturity due to clients cashing in.

Answer 1

Your have made several legitimate points and I will add some of my own.

Share price is reduced by the exact amount of the dividend on the ex-div date so there is no gain from receiving a dividend. It provides zero total return.

If the dividend is received in a non sheltered account, it has a zero cost basis and is fully taxed, though if qualified, it will be at a lower rate. Therefore, a non sheltered dividend results in a negative total return.

A "self made" dividend (selling an equivalent number of shares on a non dividend stock) has the same monetary result as withdrawing the dividend on a same price stock (your money is returned either way). The difference is that the "self made" dividend reduces the number of shares going forward and you eventually run out of shares to sell.

If you reinvest the dividend, you end up with more shares at a lower share price (ex-div share price reduction). Because you own more shares, there's a compounding effect. If share price rises, owning more shares increases total return. OTOH, if share price decreases, reinvesting the dividend results in negative total return. And should the company increase its dividend and share price grows, it enhances this effect.

My conclusion is your own words:

The only plus that I can imagine is that when and if the dividend is reinvested, the value of the increased shares at the lower price remains exactly the same (no advantage, no actual income change yet). The increased cost basis more or less offsets the necessary tax paid, but only at some time in the future. However, since the reinvestment is a purchase that does buy a slightly higher share count, of still the same value, more shares in the fund could earn a little greater gain in the future.

If you want to see some numbers, set up a spreadsheet for two stocks at the same price with the same percentage annual share price growth and same dollar investment. For the dividend stock, pick a dividend rate and a dividend tax rate. The comparison will quantify this compounding amount (or utilize a DRIP calculator).

One last comment as an example. The norm when discussing total return is that over X years, stock (or fund) has provided an 11% total return and 4% of that came from dividends. While that's simplistically true, it's really a misstatement because in order for a dividend to become true income, share price must recover by the amount of share price reduction on the ex-div date. Only share price appreciation creates total return. A dividend does not. So in this example, perhaps something over 10% of the return came from share price appreciation and a small amount came from compounding. However, calculating that is complex so it's just easier for the financial industry to say that over X years, stock (or fund) has provided an 11% total return and 4% of that came from dividends.

Answer 2

You said the dividend comes from "cash reserves" but where does that come from?

The money that pays out dividends usually comes from profitable operations, and the dividend historically has been a way to share cash flow from profitable operations with the owners of the firm. It's worth noting also for some corporation types, dividends are mandatory by regulations and the tax code (almost all partnerships, REITs in real estate, and MLPs of which there are many in the energy sector).

In some cases, the money that pays out the dividend is from debt. This is a way for hostile takeover private equity companies to pay themselves off after moving to take over control under the cover of a theory of management that there is an ideal debt load to focus management attention.

It was my own fund money returned either way.

In the case of a mutual fund, there is some truth to this; but in an individual stock, this is not true. When you bought your shares, you gave your money to the prior owner (unless you're a founder or got in on the IPO). Your money is not commingled with the funds that pay out the dividend. Your equity (the percentage of the firm you own) is unchanged by the dividend payout.

You are absolutely correct that reinvesting dividends leads to different results. When I was 6 months old, my grandmother put $1000 in my name in a dividend reinvestment plan. Some got turned into semesters of college, and I still receive about $1000 per year in dividends from the current investment today.

Answer 3

It's not right to think of dividend as being a net bad thing, because while there is a tax consequence in terms of timing, it doesn't reduce your net value at all.

Let's say I own a stock at $10 a share for 100 shares ($1000 total value), cost basis $5/share. So I have $1000 total value, and if I sold right now I'd have $500 in (assume long term) capital gains, taxed at (for simplicity) 20% on the $500 - $100 - so $900 in total.

$1000 - ($1000-$500)*0.2 = 
$1000 - $100 =
$900

Then, let's say instead I have the same stock, and they give a $1/share dividend. Then I have 100 shares at $9 a share + $100 cash. I then immediately sell all of the stock.

I thus would have: $100 taxed at 20%, plus $900 with a cost basis of $500, which means I have $400 taxed at 20%. $100 total tax again! This assumes they are qualified dividends, and the stock is held for more than a year.

$100 - (0.2*$100) + $900 - ($900-500)*0.2 =
$100 - $20 + $900 - $80 =
$900

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This makes dividends a good thing. Even if you immediately sold all of your stock, you'd be in the identical position, tax wise; but the dividend can now grow! Let's say you instead reinvest your dividend in the same stock.

100 shares ($9/share) + $80 -> 109 shares (+$1). 100 at $5 and 9 at $9 cost basis (throwing in an extra dollar).

Then, you wait, and the stock grows. Now it's at $15 a share, a few years later. Nice job investing! You now sell. What would you have?

100 shares at $5 cost basis, sold for $1500, gross profit $1000, tax (20%) $200; final amount $1300.

9 shares at $9 cost basis, sold for $135, gross profit $54, tax (20%) $11; final amount $124.

Total: $1424

$1635 - ($1500-$500)*0.2 - ($135-81)*0.2  =
$1635 - 200 - 11  
$1424

Had the stock not paid the dividend, and grown the same amount in price (to $16/share), what would you have?

100 shares at $5 cost basis, sold for $1600, gross profit $1100; tax (20%) $220; final amount $1380

$1600 - ($1600-500)*0.2 =
$1600 - $220 =
$1380

You're short $43 (plus the dollar you threw in for the original reinvestment)! That's because you were able to invest the dividend and grow it further, starting at a net-zero point, and the cost basis of that investment was higher. Of course, we could've done the same thing investing in ... anything else, really, as long as it grew equivalently.

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This of course assumes that the company's stock grows the identical dollar amount (not proportion). That is an assumption that is not always true; but it largely depends on the company and where it is in the growth cycle. I wouldn't want Tesla to pay much in the way of dividends right now, because the company is growing; every $1 Tesla has is turned into many $ of value. Mature companies, though, say IBM or AT&T, don't really need as much cash to expand - they might still have some room to grow, but it's not this exponential growth of a newer company. I want them to pay a dividend, unless I think they're going to add value from that cash at a faster rate than the market - not that they themselves will grow in value, but that the added value to their growth would be higher.

That's not to say any company should hold zero cash - United and Delta are good examples of why this is definitely not true - and massive companies like Apple and Google need a lot of cash to be able to acquire other companies, which hopefully would grow the value of the company by more than the market rate. (Maybe not, of course, but that's the hope.) But a company sitting on cash that's more than it needs as a buffer, and is more than it needs to expand or acquire other companies, is net hurting my bottom line, and I'd be better off with that cash either re-invested in more shares of the company, or in shares of some other company.

Answer 4

When my bank pays monthly interest (such as it is), my deposit increases by the amount instead of decreasing by the amount. That is a major difference.

It’s only a “major difference” because:

• your bank balance is not a price; and
• your interest gets paid into the same account that generates it.

If it were possible to sell your bank account, you wouldn’t be willing to sell it for the balance shown on your statement - you’d be willing to sell it for the balance plus any interest you’ve earned, but haven’t been paid yet by the bank. If you suppose that:

• the value of your bank account is the current balance, plus interest earned but not yet paid; and that
• the interest you do receive will be paid into a different account

then the value of your bank account will behave exactly like you observe stock values to do - the value will slowly increase as you earn interest, and then drop again when that interest is actually paid.

There are many problems with doing so, but for a very simplistic analogy you can visualize that when a company makes money and does not pay it out as a dividend, it’s something like the bank paying interest into your account with that bank. When a company makes money and does pay it out as a dividend, it’s something like the bank paying your interest into a different account of yours. Either way, you’re earning some money, and it’s ending up in one of your buckets or another.

What am I missing? Why invent dividends?

The value of a stock is the value (discounted for time and risk) of the cash flows it’s going to pay out over its life. These cash flows could come from dividends, from share buybacks, from a distribution of remaining assets when the company is wound up, or from any number of other sources. The only reason anyone would pay money for a stock is this expectation that the stock will pay out (more) money to them in the future. Of course, any individual shareholder might also convert a stock into cash by selling it, but this is only possible if someone is willing to buy it, and the only reason anyone would be willing to buy it is because of this same expectation that the stock will pay out (more) money in the future, and so on. It’s also only possible if the market for your shares is sufficiently liquid to sell at a fair price, and for investments in many private companies it may not be.

The good thing about a dividend is that you get some of those cash flows now, in your hand, in real cash money. A stock has value because of the expectation of future cash flows, but a dividend transforms that expectation into an actual real cash flow, and having cash in your hand now is always better than having the expectation of that same amount of cash at some unspecified point in the future. As long as it’s just an expectation, then you might get less than you expect, and you might get nothing. This uncertainty over an expected future cash flow reduces its value, but when you have cash in your hand, there’s no uncertainty anymore. You can buy sandwiches and shoes with cash from dividends, but you’ll be lucky to find a store which will accept your stock as payment.

So why invent dividends? Fundamentally because people gave you their money to finance your business, and they’re expecting to get some money back. The fact that, in some cases, some people may have some alternate methods to get some money back doesn’t make dividends a less legitimate means of doing so.

I know it is added to the gain income, but I mean, what is the rationale for that?

You can think of the share price, at any given time, as the discounted value of all the cash flows that will be paid out, but haven’t been paid out yet. This includes next week’s dividend. But next week it won’t include it, because that dividend will have been paid to you already, so the price will be lower. Does this drop in price mean something bad happened? No, it means something good happened - you were paid cash money.

So to compare the performance of two stocks over a given period of time, you need to consider the value it’s generated which hasn’t been paid out yet - basically, the change in the stock price - and the value it’s generated which has been paid out - basically, the dividends. Otherwise, an equivalent investment which has paid you a lot of cash will appear to have performed worse that one which has not, and that's not the right conclusion to come to if they're equivalent.