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My question should be more like: why dividends are inseparable from the appreciation of a stock's price?

The common explanation is something like:

Stock A pays a $10 (10%) dividend and a share is worth $100. Stock B pays no dividend and is also worth $100/share. If they both grow by 10% at the end of the year, you would have the same return on the both of them. This is because A's prices goes up to $110 and after paying a $10 dividend, A's share price goes down to $100. B's price grows to $110. 100+10=110

Makes sense. But not to me. I don't know why but I can't wrap my head around why the dividend takes money away from the share price. I thought the share price was the price for the piece of the company, and not the money is pays out. Is that not true?

To me, I see a dividend as the same thing as income from renting out a property. If you own a $100k house (assume no mortgage) and you rent it out for $1k/month, your yearly income from the house is $12k (12%). If the price of the house goes up 10%, then you still have the $12k but also $110k house so your total net worth is $122k. But if you (for the sake of argument) just owned the house so that it appreciates in value and did not rent it out, you would be $12k short at a 10% growth. This is because rental income is separate from the value of the house, obviously.

Why are dividends not the same? Why do dividends take money out of share price and not considered income from the company the same way rent is income from property?

As an aside, I understand that stocks that pay dividends are not automatically better than stocks that don't. That isn't my claim. Dividends are irrelevant in determining whether a stock is a solid investment (that is not to say they are irrelevant to your returns, see this calculator).

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    Are you saying that "government taxes are irrational" ... ? The only answer can be "that's life". – Fattie Jul 21 '20 at 0:46
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    If you bought this house 50-50 with a partner, on the expectation that you would always give the partner $6000 per year (whether rented or vacant), that would be the equivalent of the dividend in your example. – user662852 Jul 21 '20 at 4:56
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    Dividends come from the company itself. It's like if you went and took a tree from your house each month. It doesn't matter whether you leave the tree there or take it away, either way you have the value of the tree plus the value of the rest of the house. – user253751 Jul 21 '20 at 10:20
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    This (much repeated) premise about dividends is flawed. What it misses is that in both theory and empirically a stocks price rises the amount of the dividend and then drops that amount. The only difference between theory and the reality is a great mystery of finance: the aggregate drop in price is less than the rise. – JimmyJames Jul 21 '20 at 14:57
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    @JimmyJames: Perfectly efficient markets are like spherical cows, or doing your physics problems without taking friction into account. – jamesqf Jul 22 '20 at 15:31
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I will give a counterpoint to Bob Baerker's answer.

When your tenant pays you your rent, it does not decrease the value of your house.

It doesn't decrease the value of the house as a physical asset, but it does decrease the value of the house as a financial asset. When you have a tenant, your house is encumbered by a rental agreement (either lease or month-to-month).

Let's say a buyer is required to assume the rental agreement (keep the tenant on the same terms until they can otherwise be renegotiated). Suppose the tenant pays $1,000 rent for August on August 1.

Just before the tenant pays, let's say the buyer is willing to pay $X for the house. That deal includes the buyer receiving the tenant's August rent payment (because the rental agreement has been assigned to the buyer) and continuing to grant the tenant use of the house for the month of August.

On the other hand, if you sell just after the tenant pays you the rent, then the buyer has the same obligation to grant the tenant use of the house for the month of August, but the buyer does not receive that $1,000. It follows that the buyer is willing to pay $(X - 1,000) for the house.

So, a house and a stock are more similar than they may seem. The economic value of a company includes not only its physical assets but also its claims (loans and deposits, accounts payable and receivable). Likewise, the economic value of a house includes claims like rental agreements, liens, etc.

Whenever there is a contractual discrete cash flow whose recipient is determined by who owns property on a particular date, the market value of that property will drop immediately after that date as a new owner will no longer be entitled to that payment.

The value will exhibit a characteristic sawtooth pattern versus time. Even if the physical attributes are stable, economic value builds up gradually as claims (hopefully) accumulate from profitable use of assets, then jumps down when cash is extracted. In between rent payments, the house value has an extra increasing trend because the tenant is using up the month they've paid for, and the owner's remaining obligation to the tenant is declining.

It would be difficult to demonstrate this empirically with real estate since the property value is not precisely quoted daily and value of one month's rent is likely lost in the noise of illiquidity, but the principle is valid.

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    @MrMineHeads Correct, company A is profitable but does not invest in growing its operations. It just collects profits in its bank account and periodically distributes them to shareholders. The variations in stock price are entirely due to the timing of the dividend. However, stock A has genuinely provided a 10% return. – nanoman Jul 21 '20 at 3:47
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    @LasseMeyer Yes, stock prices usually go down after dividends have been paid (technically, after the date entitling shareholders to the dividend -- it may actually be paid days or weeks later). But the point is that the benefit of buying the stock "cheap" is counterbalanced by not receiving the dividend. Or put another way, you're not actually buying the company at a cheaper valuation, because you're buying a "poorer" company with less cash in its bank account (by the amount of the dividend it just paid out). – nanoman Jul 21 '20 at 11:27
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    @Lasse Meyer - Stock price always goes down by the amount of the dividend because stock exchanges reduce share price by that amount on the ex-div date. This isn't always apparent the next day because if there's buying and share price rises, it can mask the reduction. nanoman makes an important point. In terms of valuation, after the ex-dividend reduction, the stock hasn't gone on sale. It's a "poorer" company due to the pending dividend pay out. However, many people do indeed buy a stock post dividend because it appears cheaper. – Bob Baerker Jul 21 '20 at 13:44
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    @Gnudiff You receive the full dividend if you own the stock as of the night before ex-dividend. You could own it for as little as 8 hours if you buy after-hours and sell premarket the next morning. – nanoman Jul 21 '20 at 21:56
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    @BobBaerker I'm not talking about trading resuming the next day, I'm talking about actual trades at close on the ex-div day. Also, by price I'm referring to the value at which one can buy or sell the asset (as I believe are most people since that is what has relevant meaning in the context of this question), not what an exchange lists as the price in historical data. – Travis Jul 25 '20 at 18:05
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Just to give an alternative analogy to the other answers:

Think of a company as being like your bank account. If the bank account has $100 and it earns 10% interest per year:

A) If you decide to keep the interest in the account, then at the end of the year the account has $100 + $10 = $110. This is analogous to a company earning profits of $10 and retaining those profits.

B) If you decide to withdraw the interest in the account, then at the end of the year the account has $100 but you have $10 in cash = $110. This is analogous to a company earning profits and paying them out as dividends. The bank account / company is worth $100 instead of $110 because it now no longer has the extra $10.

If you own a $100k house (assume no mortgage) and you rent it out for $1k/month, your yearly income from the house is $12k (12%). If the price of the house goes up 10%, then you still have the $12k but also $110k house so your total net worth is $122k. But if you (for the sake of argument) just owned the house so that it appreciates in value and did not rent it out, you would be $12k short at a 10% growth. This is because rental income is separate from the value of the house, obviously.

This analogy is incorrect. With the company that doesn't pay dividends, it is still earning the profits of $10, just choosing not to pay them out to shareholders. In your example where you don't rent out the house, you are failing to make any profits at all. These are not comparable scenarios. The correct analogy is that you rent out the house for $12k, but instead of receiving that money as income, you re-invest it into the house (e.g. by improving or enlarging it). If we assume that $12k of improvements results in $12k of extra value on the house, your house is now worth $122k as expected. This is what happens with the non-dividend paying company: the $10 that it fails to pay in dividends is retained in the company and increases its value by "improving" it (by increasing it's cash balance).

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    This is a very good analogy for the comparison of dividends and rent. It deals in actual value rather than esoteric economic value. +1 – Bob Baerker Jul 21 '20 at 13:59
  • The problem with the bank account analogy is that the book value of a company is not the market valuation. If you can find a where the book value and market valuation are equal, it's probably a failing one. – JimmyJames Jul 29 '20 at 15:03
  • @JimmyJames True, but analogies are aids to understanding rather than accurate definitions. – JBentley Jul 29 '20 at 22:19
  • Unless they are misleading. Then they can inhibit understanding. The book value of a company has a very indirect and subtle relationship with the stock value. The book value of a bank account is its value. It's revenue that is core to the valuation of a company. The amount of cash on hand is a factor but has no direct 1-to-1 association with its value. Therefore the idea that the value of the stock dropped by dividend amount because it has that much less cash is preposterous but that's the implication of your analogy. – JimmyJames Jul 30 '20 at 15:49
  • @JimmyJames Revenue is a part of the value of a company, but there is no denying that cash has value. Ceteris paribus, if company X has $1 more cash than company Y, then it is worth $1 more. Similarly, if a company has $100 in its bank account today, and tomorrow it has $99 because of a dividend payout (i.e. nothing else to show for the $1 spent), then ceteris paribus it is worth $1 less than it was yesterday. There is nothing preposterous about that, it is basic accounting principles. – JBentley Jul 30 '20 at 23:11
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What's the difference between dividends and rent?

When a dividend is paid, that cash is removed from the company, decreasing the company's value. For that reason, stock exchanges decrease share price by the amount of the dividend on the ex-dividend date.

When your tenant pays you your rent, it does not decrease the value of your house.

Suppose that share price was not reduced by the amount of the dividend on the ex-dividend date. For ease of discussion, let's pretend that per your example, it's a $10 dividend paid once a year. Everyone would buy your $100 stock at the close the day before the dividend and in the morning, the stock would be $100 before trading opened and the company would owe you $10, to be paid on the Payable Date. Now what's wrong with that picture?

I think that dividends being taxed as income (if received in a non sheltered account) has led to a massive misconception by the public that dividends are income. They're not. They are merely cash flow from the value of your equity positions and in and of itself, a dividend provides zero total return. Only share price appreciation provides total return. Note that this refers to what is happening to share price and in your brokerage account on the ex-div date not the corporate side (dividends come from earnings).

Another Catch 22 issue is the relevance of dividends to one's return. The powers that be often state the S&P 500 has returned X% over some number of years with Y% coming from dividends. Let's pretend that it's 7% (total return) and 2% (average yield). In reality, it all came from share price appreciation.

As previously mentioned, dividends provide zero total return. However, when reinvested, they alter the calculation because now you have additional shares compounding the return when share price appreciates. While it is possible to break these apart by using adjusted share prices, it's a royal headache to do so. An easier way is to just use a DRIP calculator and compare the total return of reinvesting versus not reinvesting. Here's one such calculator. Just understand that all of the gain comes from share price appreciation. If share price drops (actual drop due to selling, not ex-dividend reduction) then there will be negative compounding.

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  • Paragraph 4 is the bottom line. i.e. if the price were not adjusted, the result would be strange. – JTP - Apologise to Monica Jul 21 '20 at 19:27
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    If one could buy a stock at the close, be entitled to the dividend the next morning (ex-div) and not have share price reduced, there would be no reason to buy other stocks. Just buy near 4 PM, sell in the morning, repeat every day, and laugh all the way to the bank. OK, time for all of the 'free money' dreamers to give up the fantasy :->) – Bob Baerker Jul 21 '20 at 19:44
  • When your tenant pays you your rent, it does not decrease the value of your house. — then why is it much cheaper to buy an apartment that is rented out than one that isn't, at least in countries with tenancy protection? If I buy a home that is unoccupied, I can choose to live there tomorrow or rent it out. If I buy a home that is rented out, I may not be able to get the tenants out in the next 50 years (i.e. until they move out or die, and I'm not sure about the latter). – gerrit Jul 22 '20 at 7:38
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    "Why is it much cheaper to buy an apartment that is rented out than one that isn't, at least in countries with tenancy protection?" With that logic, a stock should cost less because it is "going" to pay a dividend. Unfortunately, it doesn't work that way. As for your inability" to get the tenants out in the next 50 years until they move out or die" that has nothing to do with anything other than the fact that they have a rental contract. Again, irrelevant to the dividend versus rent comparison. – Bob Baerker Jul 22 '20 at 18:04
  • "They're not. They are merely cash flow from the value of your equity positions and in and of itself, a dividend provides zero total return. Only share price appreciation provides total return." Can you provide a reference for this non-standard assertion? – JimmyJames Jul 27 '20 at 18:21
2

The house example can be appropriately modified, without concerning the actual sale of the property (which is a good example, also), to match the stock market.

The rent the tenant pays is the source of income for the house, not for the owner of the house, in this example. The house is the company, remember! Just like a company that sells widgets would sell $10k worth of widgets, and that would cause its value to appreciate by $10k, the house sells tenancy, and so appreciates in value by the rent paid for it. That's separate from appreciating in value due to the market, or due to capital improvements, or any other reason the value might increase: it's simply an increase from income. So the house is worth $100k, plus the accumulation of rents it has taken in but not yet paid out.

In your example, you immediately take that "dividend" of rent from the house - which is not directly possible with a public company, but only because of SEC regulations. But you could just as easily have taken that money and built an addition, right? Just like any public (or private) company, which has income, can make a similar choice:

  • Dividend that income back to the owner(s) - value of company reduces by dividend $
  • Make capital improvements - value of company changes based on perceived value of those improvements (could go up, down, or stay neutral)
  • Keep cash in reserve - value of company stays neutral

If you did keep the house in a company (as some people do!), then you would have exactly the same math to do - that company's value would decrease each time you took a payout (dividend).

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Because a stock and a house are inherently different things. To compare them more meaningfully, consider them in a more equivalent way. The stock is ownership of (part of) a business. That business includes employees (who provide labor) and assets, and generates some amount of profit (or loss). The house is just a house; you need to put it your own time and effort (and money) to maintain it, find tenants, collect rent, pay taxes, etc. You could consider that whole enterprise (the house plus all your associated work) as a company.

If we assume stock A and stock B are both companies whose business is "being a landlord", and they each own one (approximately identical) house, then (a very simplified, not-exactly-realistic, version of) the scenario in your question looks like this:

  • Company A owns a $100,000 house (and nothing else) and has no debts/expenses. There are 100 shares of the company, so each share is worth $1000. The tenants pay $1,000 in rent, which is immediately paid to each shareholder as a $10 dividend. The company still owns exactly $100,000 in assets (the house; ignoring depreciation, maintenance, etc.), so each of the 100 shares is still worth $1000.
  • Company B owns a $100,000 house (and nothing else) and has no debts/expenses. There are 100 shares of the company, so each share is worth $1000. The tenants pay $1,000 in rent, which the company keeps. The company now owns $101,000 in assets ($100,000 house, $1,000 cash), so each of the 100 shares is now worth $1010.

If I buy a share of company A, I get a piece of ownership of a business that owns a $100,000 house. If I buy a share of company B, I get a piece of ownership of a business that owns a $100,000 house and $1,000 in cash. That additional cash may be paid out as a dividend in the future (bringing Company B in line with Company A), or it may be used for further investment (e.g. buying a second house, improving the first house to increase rent, etc.).

1

A company's share price is essentially a combination of two things:

  1. The value of all the company's assets (its book value), and
  2. investors' estimate of the future prospects of the company (is this a "good investment?").

The assets include the cash in the company's bank accounts. When they pay out a dividend, they have less cash in the bank, so their book value drops. If nothing else has changed, it simply makes mathematical sense to decrease the share price accordingly.

In reality, things aren't quite that simple. For some investors, the prospect of receiving regular dividends is what makes a company more valuable than some other similar company. It's similar to the reason why some people buy bonds rather than stocks -- even though the overall returns may be less, the security of receiving payments on a regular basis is valuable in itself.

But at the moment that the company pays out its dividend, these effects can be ignored. It's still the case that the company's assets have been reduced, so no matter what you think about whether it's a good investment, it can't really be as valuable as it was when it had that cash in the bank.

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  • If you take Clorox (CLX) the book value per share is around $5.5 and the stock price is around $230. So based on your claim here, 97% or more of the value is based on investors future prospects of the company. This is Clorox, not some startup. Does that really make sense to you? If there was a company that just held dollars and paid people (with those same dollars) to manage them (until they were all gone), would you value it at the book value? – JimmyJames Jul 29 '20 at 19:14
  • What else could that other 97% be based on? "future prospects" also includes things like safety -- how likely is the company to still be around and successful in the future? So a blue chip company like Clorox is worth the high price because you're not likely to lose your money (but don't forget about General Electric). This is the difference between value and growth investments. Stock pricing is not a simple thing. – Barmar Jul 29 '20 at 21:12
  • I would think revenues would be a big factor. That's kind of the point of a business, is it not? Book value has almost nothing to do with profits. Probably the most common measure for a company is it's PE ratio. If you look at CLX stats, the dividend payout is a tiny fraction of it's monthly revenues. Any impact on their book value should be pretty fleeting. It's kind of like how when I make my monthly mortgage payment, my net worth doesn't go down. I'm paying it from my income, not my savings. – JimmyJames Jul 29 '20 at 21:27
  • @JimmyJames Expected revenues are part of what goes into estimating future prospects. – Barmar Jul 29 '20 at 21:28
  • "future prospects" is everything that goes into evaluating the company that isn't just "stuff". – Barmar Jul 29 '20 at 21:30
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I have once seen the question from another angle that should explain to you why the value decreases and why it has to decrease:

Imagine you've got stock that pays dividend. If dividend is paid once a year, why to buy such stock and keep in it your money for entire year if you could by 1 day before paying out dividend (actually the day it is decided you will get dividend if you hold the stock) and then the next day collect the dividend and sell the stock immediately just to repeat the process next year.

And the answer is - immediately after paying out dividend the stock price drops by approximately the dividend amount just to limit people from earning the money that way.

Going back to renting house example you have used - imagine you rent a house, you've got permanent tenant in it paying the rent and the rent is paid once a year. You can then sell the house along with tenant but it is clear that the value of such transaction will vary over they year. Once it is close to the rent being paid it is higher (approximately by the amount of the rent you will immediately get back) and will be lower when the rent will be paid in longer period. If you think this way it is very logical conclusion the price of such asset (not only being asset but a rented asset) must drop immediately after rent is paid.

0

Say that you own an LLC that owns a house worth $100k and rents it out for $12k/year like your example. That $12k is revenue for your LLC. Your LLC will have to pay property taxes and for other things like accounting, so let's say you have $7500 cash in the account at the end of the year. And let's say the housing market jumps so the house is now worth $110k.

You could pay yourself the $7500 which would be like a dividend. Now the LLC's only assets are the $110k house.

Another option would be to keep the money in the LLC. The LLC now has has assets of $117,500. You may be saving up to buy a second rental property. Or you could use that $7,500 on improvements to the property (landscaping, electric water heater, whatever) which would increase the value beyond the $110k.

That's what a company that doesn't pay dividends is like. You don't get that regular income, but the expectation is that the money will be used to make the company more valuable and increase the stock price.

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I understand that your title and your question differ wildly. And other answers tackle that beautifully. However, because others are likely to come here based on the title, which currently is "Why are dividends different from property income like rent" and I would hate to see them disappear frustrated when I have the answer to that question as stated.

Dividends are taken from the available cash of a business. This cash has already been taxed by a corporate tax, so it is not taxed at the same rate as regular income. As a more personal finance related example, keeping in mind this varies from jurisdiction, so talk to your accountant to find the breakeven point, in my area if you're self employed and making 250k a year (500k if married) then you want to pay yourself a salary up to about that 250k and after that declare dividends. At that point, the personal tax becomes high enough that you are better off eating the corporate tax on the "profit" of the business and then eating again the tax on dividend - the two of them add up to less than the top tax rate.

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  • I am not the downvoter, but I have a correction: dividends come out of profits or retained profits, not cash. It's an important distinction. A loss making company can have available cash for example, but would not pay dividends from it. – JBentley Jul 23 '20 at 12:11
  • @JBentley It's an important distinction, but not a correct one. Companies can take a loss and still declare a dividend from available cash flow. Many choose to do so in order to not spook investors if they have a bad quarter, for instance. However, what might be considered important is that the cash paid as a dividend is taxed - you cannot write it off as a loss if you pay it out as a dividend. See money.stackexchange.com/a/52120/3093 for a bit more background on that. – corsiKa Jul 23 '20 at 23:54
  • That is why I said you can pay dividends from profits or retained profits. The latter covers the situation where a company is loss making but has previously retained profits available and spare cash. It is unlawful in most jurisdictions as far as I know (and certainly in the UK) for a company to pay dividends where there are no available retained profits (i.e. out of capital). See e.g. here or here. – JBentley Jul 24 '20 at 20:03
  • And if you think about it, the reasons for it being unlawful are fairly obvious: it would be a fraud against the creditors of the company, because they are first in line before shareholders in the event that the company is liquidated. If the company has paid dividends without retained profits, then they must have been paid either by increasing the liabilities e.g. via a loan (thus effectively cheating some portion of the creditors) or by out of capital (cheating the creditors because that capital is what the shareholders agreed their liability would be limited to). – JBentley Jul 24 '20 at 20:08
  • @JBentley Your "fairly obvious" line of reasoning doesn't really make sense. Creditors know that shareholders are important to a corporation. As long as you're making your payments to the creditors, they really don't care. – corsiKa Jul 25 '20 at 20:37

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