Is Dividend Irrelevance Theory for Real?
A stock dividend is a nice little gimme for shareholders. Some publicly traded companies offer a cash payout to reward their investors at the end of a quarter. Most investors like them, in fact, some even built their portfolio’s around them. But no good deed goes unpunished, enter the Dividend Irrelevance theory.
Dividend irrelevance theory is the brainchild of two financial analysts, Franco Modigliani and Merton Miller. In 1961, they offered a now-famous paper stating that companies should do away with dividends and reinvest their earnings. They posited that taking any other course could damage the health of the business. Despite the popularity of dividends, interest in this theory continues to resurface over 60 years later.
There are two schools of thought on the theory. First that it’s total hogwash. Investors lean toward companies that offer dividends which is what keeps the company healthy. On the flip side, others think dividends are useless. They also argue that dividends decrease the share price by the same amount as the dividend. Questions about dividend irrelevance theory were a thread on Reddit just last week.
We’re going to present both sides of the argument. First up, the “hogwash” perspective.
Dividend Irrelevance Theory is Wrong
The first premise to debunk is the idea that dividends are irrelevant to investors. If that were the case, blue-chip stocks would surely stop issuing them. But they don’t. Companies like Walmart, PepsiCo, and Johnson & Johnson, regularly pass on dividends to their shareholders. They don’t appear to be hurt by that practice. In fact, prior to dividend distribution, stock prices of these companies are known to rise.
It’s human nature that people appreciate rewards for their decisions. Smart companies know that and respond accordingly. It doesn’t appear any of them are going out of business anytime soon.
The next premise is that dividends are subtracted from the price of the stock, nullifying their benefits to the company and the investors. There are so many factors that affect the price of a stock, it’s a bit naive to blame dividends. Analysts are continually evaluating stocks. Those assessments include a company’s financial performance, management quality, and debt. The analysis includes dividends and their standing in the industry as well.
If a stock pays out a $2.00 dividend and immediately drops in price by $2.00, there should be plenty of quantitative data to prove it. One of the advantages of creating a theory in 1961 is the inability to measure it. The technology used today can measure how many times the CEO sneezed. Okay, maybe not that, but if there was data to support this theory – it wouldn’t be a theory, it would be a fact.
An underlying premise of the theory relies on the idea that market value is perfectly aligned with book value. This is not accurate. Book value is determined by totaling up a company’s assets then subtracting its liabilities. Identifying book value per share comes from a calculation called the “Price/Book Value” ratio. The outcome may or may not correlate with the stock’s market value.
Market value is determined by quantitative and qualitative data. That includes governance and external economic conditions. Market value is simply how much an investor is willing to pay for an asset, based on the analysis available. Market value can be inflated, as was done by the three corporate credit agencies during the subprime mortgage implosion. Millions lost millions, by thinking that the book value was equivalent to the market value.
Stock prices are not indicators of a company’s value. They are indicators of what investors are willing to pay per share.
Dividend Irrelevance Theory is Right
One of the first arguments we hear against the theory is that investors love dividends. Are we saying that investing in a company simply because they pay dividends smart? It’s not but investors love shiny objects. Kiplinger says dividend-paying stocks cost more per share and historically deliver lower returns.
Successful investors take cost and risk into consideration. Buying a stock because you might get a couple of dollars per share four times a year seems irrational. Not to mention you have to pay taxes on them.
Paying dividends has nothing to do with increasing profit. Profit is what people should be looking for in an investment. Companies that make a profit have the capital to grow the business, which in turn, generates more profit. Stock prices rise and investors see a higher return on their money. It’s practical, especially for savvy investors who follow a long-term strategy.
Dividends are an expense that siphons profit from the company. By giving out dividends, a company loses money that could have gone to R&D or further capitalization. The value to the investor is limited too. The S&P 500 puts the average dividend at 1% or 2%. By usurping profit from the business, investors hurt future profitability which may reduce the value of their shares. All for a small reward.
Book value equals total assets minus total liabilities. Dividends are a liability. If that’s the case, the payment a shareholder receives gets subtracted from the book value of the asset. Investors chasing dividends get a cash reward, which is nullified by a similar reduction in share price. It’s not only your 1 or 2% – it’s the sum of every dividend that gets paid out. It’s like investors are ganging up on themselves. In the end, no one gains.
Investors claim dividends offer “cash on hand.” Any investor who needs cash should be able to get it without waiting for a dividend. Your liquidity shouldn’t be dependent on a company’s dividend policy. No company has to issue dividends. Sometimes even companies that normally issue them will hold off. During the pandemic, starting in April of 2020, $220 billion in dividends were cut by year-end. Imagine trusting that cash would be “on-hand.”
Dividends are not worth it. They don’t generate profit for the company or increase the wealth of investors. They are irrelevant.
What About EFTs?
An Exchange Traded Fund (EFT) is a collection of stocks that track against an index. The oldest and best-known example would be the S&P 500 index. Some of the stocks in the index pay dividends. EFTs pay dividends to the fund itself. They use the profits to buy new assets or more of the stock that produced the dividend. It’s a strategy called dividend growth investing. By reinvesting in the fund, everyone’s shares get a bump.
EFTs also make dividend payments to shareholders. Unlike stock dividends, there is no set timeline for when they’re paid out. The fund collects and holds the dividends in an account, then issues the payments in one lump sum. Investors have to own shares by the date the dividend is recorded. Stock sales can lag, to get the dividend you’d need to buy the stock at least two days before.
When it comes to the Dividend Irrelevance Theory, EFTs are kind of a wash. They hold dividends in the fund and sometimes apply them as reinvestments in the fund’s profitability. They also distribute dividends to fund shareholders.
Summing it up
After reviewing both sides of the argument, one thing jumps out. If the share price was immediately reduced because a dividend was issued, there would be data to prove it. When Modigliani and Miller wrote that paper, the only available technology a few landlines and the post office. The technology and analytics available today were unfathomable back in the day.
With no offense to the authors, there are several factors that haven’t aged well. The notion that paying dividends will damage a company is debunked by the largest companies and blue-chip stocks on the market. Those firms regularly issue dividends and their health is and has not been negatively affected.
Whether Modigliani and Miller agree or not, investors like to invest in stocks that offer dividends. It can be argued that Dividend Irrelevance Theory ignores the influx of cash those investors deliver. Those investments provide for capital expenditures that strengthen the company. They support growth and higher industry standing. These are things both sides agree will make a company stronger and more viable long term.
It’s true that dividends could be damaging when a company is in financial distress. Any firm that issues junk bonds to pay down debt should not be paying out dividends to shareholders. And if they are, there is a serious leadership issue that extends beyond dividends.
Dividends are not irrelevant. They attract investors and encourage investment. The Dividend Irrelevance Theory is 60 years old. Too much has changed for it to be relevant today.
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