A quick search for stocks with growing dividends returns over 1.5 million Google results. The popularity of dividend investing suggests that it is a perfect stock investment strategy. Buy a stock with a growing dividend or a high dividend fund and you’re assured future cash flow.
Then there’s the retirement wisdom that instructs you to spend interest and dividend income and leave capital gains income alone.
But, dividend investing isn’t all that it’s cracked up to be. There might be more “mental accounting” in a dividend investing approach than rational behavior. “The Effect of Dividends on Consumption” a Brookings Paper on Economics by Baker, Nagel and Wurgler expounds on this topic: “consumption indeed responds much more strongly to returns in the form of dividends than to returns in the form of capital gains.”
In short, we’re more comfortable spending dividends than in selling shares of stock for our spending. Here’s why that approach is illogical.
How Does a Dividend Impact a Stock’s Value?
A company earns profits and then decides what to do with those profits. The firm can reinvest those profits back into the company and attempt to create more shareholder value. Or, it can pay out all or part of those profits to shareholders in the form of a dividend and you can decide how to spend the money. When a dividend is paid out to you, the shareholder, the value of that stock declines by the amount of the dividend payment.
Imagine that you own a share of “The Amazing Company.” The company is valued at $50-per-share. Amazing pays a $5 dividend and after the payout, the share price drops to $45. Yet, you have your share, now valued at $45 plus your $5, so you still have $50 worth of assets.
If the company believes it can earn more money by reinvesting that $5 in the company, then the stock price would remain $50. Either way, your asset value is $50. When you buy a dividend-paying stock, you believe that you can better spend the dividend payment than can the company.
Realistically, a dividend-paying stock has no greater value than company shares that don’t pay dividends. If you want cash flow from a growth stock, that doesn’t pay dividends, you can sell a portion of your holdings to create cash flow.
How Are Dividends Taxed vs. Capital Gains?
As of 2018, the tax treatment for qualified dividends and long-term capital gains is the same. Depending upon your income, qualified dividends and long-term capital gains are levied either a 0%, 15% or 20% tax. So, selling shares without dividend payments for cash flow or spending the dividends has the same result.
There is research that dividend-paying stocks outperform shares without. In a JPMorgan article, the company found that dividend-paying companies show confidence in a businesses’ future, which can drive future shareholder value
A recent Financial Analysts Journal article “What Difference Do Dividends Make” by Conover, Jensen and Simpson, found that “high-dividend payers have the least risk yet return over 1.5% more per year than do non-dividend payers.” The exception to this finding is with small non-dividend paying value stocks, that return 1% more per month than their small non-dividend-paying growth stocks.
Why Isn’t Dividend Investing All It’s Cracked Up to Be
So, the upside is that there isn’t much difference between receiving dividends from a stock or selling shares for income in a non-dividend-paying stock. When seeking income from your stock investments, the important point is selecting firms that will increase in value.
Choosing stock investments is based on research and analysis. After all, a company can cut their dividend. And a non-dividend-paying firm can explode in value.
Finally, the important concern when investing is choosing firms that have a path for future growth. You can create your own cash flow by selling shares or by receiving dividends … the results are the same.
As of this writing, Barbara Friedberg did not hold a position in any of the aforementioned securities.