How are dividends good for stock/share investors?

Question

With every stock going ex-dividend, the stock price seem to drop by the amount of dividend per share.

A few observations:

• The dividend seems to be earned at the cost of capital gain. The amount gained through the dividend is offset by unrealised capital gain on the ex-dividend date.
• Also this prevents long term capital gains tax benefits (50% discount here in Australia) and you end up paying the full marginal tax (at least in Australia).

I am ignoring special dividend that types are fully/partially tax exempt (franked dividends in Australia for example).

This means I would end up paying more tax if I got dividends (as opposed to capital gains).

I am sure I am wrong somewhere; can someone please explain how are dividends beneficial (at the cost of share/stock price)?

Answer 1

We have questions on this site wondering why people would people invest if a company doesn't pay any dividends.

You are asking the opposite question: why would I want a dividend?

The answer is that it depends on what the investor is trying to do at that stage of their life. Some want a series of dividends that they will use to augment their income without the need to sell any shares. Some have their investments in tax deferred or tax free investments; so the tax impact is either delayed or avoided.

One way to evaluate an investment is its tax impact on your finances.

Some people see a growing dividend as a sign of company health, others see it as a wasted opportunity to grow the company by reinvesting profits back into the company.

Interpret the benefit of dividends based on your needs and your view of dividends.

Answer 2

Dividends are a way for shareholders to get some cash out of their investment without having to sell their shares. In the early days of the stock market, stocks could only be bought and sold in lots of 100, so if you wanted any cash back you had to sell an entire block. As time goes on it's more possible to buy/sell smaller lots (though still not always possible) but dividends became a way to give owners part of the earnings of the company without having to reduce their ownership.

Yes, they are often taxed differently (and sometimes taxed more than capital gains) but that's a decision each investor has to make - whether to buy stocks that pay dividends to get periodic cash out even if taxed differently or buy-and-hold to get cash back on their timeline.

Answer 3

How is dividend good for stock/share investors?

You're thinking about this from the perspective of the small shareholder. But you, the small shareholder, are not making the decision to issue a dividend. The major shareholders are making that decision, and they're doing it to benefit themselves.

If a company has a mountain of cash and the owners literally do not know how to spend that cash to generate more profits, they'll just take the cash for themselves. Dividends are the legal mechanism for taking money out of the company's bank account and putting it into the owners' bank accounts.

See Microsoft in the early 2000s for example. Bill and Steve wanted cash to buy stuff. The company had cash and was generating more all the time. They would rather have that cash in their pockets than pay their workers more or invest in a new line of business, so they issued a dividend.

Answer 4

A dividend is beneficial to stockholders because it increases the return on their investments.

Suppose a company has a market cap of $10,000,000 and $1,000,000 in excess cash in the bank at the beginning of a year. It may or may not issue a dividend to get rid of that $1,000,000 in cash. Then suppose it makes $1,000,000 in profit over the rest of that year.

First, let's try with no dividend: The company is worth $10,000,000 and makes $1,000,000 in profit. That's a 10% return for shareholders.

Now, let's try with a dividend to get rid of that excess cash: Since the dividend reduced the share price, the company's market cap also dropped by $1,000,000. So the company has a market cap of $9,000,000 after the dividend. The $1,000,000 in profit therefore represents an 11% return for shareholders.

An 11% return is better than a 10% return. Over a few years, this would add up quite significantly.

Of course, if there's something even better they could do with the cash, they should do that. But the point is that dividends do increase returns for investors, so other things they might do with the cash have to compete with the benefits of dividends. But if the company can't do anything useful with the cash, forcing investors to own idle cash drags down their returns.

This means I would end up paying more tax if I get dividends (as opposed to capital gains).

Correct. But if you have a capital gains tax rate of zero or hold investments in a tax-advantaged account of some kind, that doesn't much matter.

Answer 5

What dividends provide to investors is predictable income. While the dividend rate can change, lowering the dividend is a big red flag that the company is having financial troubles. So if you're invested in a company that's in decent shape (and why invest in anything else?), you can expect that the dividend will at worst stay the same, and may even increase in the future. The board of directors does have to declare the dividend before paying it out, but this is usually just a rubber stamp to keep it the same.

You can get cash by selling shares, and the tax impact of capital gains is indeed better than that of dividends in many places. But share prices fluctuate significantly, even for companies that are in good shape (often opinions of an entire industry will sour, and most companies in that industry will see their prices drop).

A common scenario is that retirees will invest in dividend-producing stocks. If you're no longer earning a regular salary, you want some other regular source of income, and dividends provide that. Without dividends, you're at the vagaries of market prices, and crashes become more scary.

Answer 6

With every stock going ex-dividend, the stock price seem to drop by the amount of dividend per share.

A lot of good discussion here on the value of dividends but I don't see anyone addressing this common source of confusion.

The stock price doesn't 'seem' to drop by the amount of the dividend. What you are noticing is that exchanges (in the US, at least), are required to mark down the last traded price by the amount of the dividend on the ex-dividend date. For example, Let's say a company issues a $1 dividend with an ex-date of today, and the last trade recorded yesterday was $100. The 'adjusted close' will be $99. When trading opens today, the last trade price will be reported as $99. The key is to understand that the actual last trade was made at $100.

If you want to see a real-world example, you can look here at MSFT price history on yahoo finance. Note that there are two 'close' columns: 'Close' and 'Adj Close'. They are almost always exactly the same. Scroll down until you see a dividend line. At the time of writing, the last MSFT dividend was $0.75 on the 15th of November 2023. Look at the price line for the 14th. You will see that the close price was $370.27, and the adjusted close price is $369.52. The difference between the close price and adjusted close price is exactly $0.75, the amount of the dividend. The close price was the actual trade price. The adjusted price is, as the name implies, an adjustment to the actual real trade price. Now look at the prices on the 15th. It opened and closed higher than the adjusted close price. That adjusted close isn't a 'real' price. That's why it is recorded separately in the price history. It's the assumed fair price for that stock after the dividend payment cannot be claimed. Real market prices are set by trades, not the exchange.

So why would the exchanges do this and, moreover, why are they required by regulators to do this? At one point, I tracked down the reasoning behind it and I could probably find it again if necessary. But, from memory, this wasn't always the practice at every exchange. Some did this, some did not, or at least the specifics were not completely consistent, hence the rule. The reasoning for doing this is that, in theory, the value of the stock prior to the ex-dividend date should be priced higher than on the ex-dividend date by the amount of the dividend. If I bought ten thousand shares of MSFT on Nov. 14th for 370.27, I would receive $7500 in cash soon after, effectively discounting the price I paid. If you bought on the 15th at that price, you would have paid much more for the same thing. If I could sell my shares the next day at the same price I bought them, I basically pocket $7500 for free. Back when not all exchanges adjusted for dividends (sometime in the 70s IIRC,) that kind of thing could and did happen when people were not aware of the ex-dividend date. So, regulators decided to make it a rule that prices would always be adjusted down to prevent the unwary from being taken advantage of in this way. This article: "Understanding Ex-Dividend Dates" explains it pretty succinctly:

When a company pays a large dividend, the market may account for that dividend in the days preceding the ex-div date by a rise in the price of the stock. This is because buyers are willing to pay a premium to receive the dividend. However, on the ex-div date, the exchange automatically reduces the price of the stock by the amount of the dividend.

Also here:

The declaration of a dividend naturally encourages investors to purchase stock. Because investors know that they will receive a dividend if they purchase the stock before the ex-dividend date, they are willing to pay a premium.

This causes the price of a stock to increase in the days leading up to the ex-dividend date. In general, the increase is about equal to the amount of the dividend, but the actual price change is based on market activity and not determined by any governing entity.

A really common misconception around this is that somehow the dividend is taken "out of the price". I don't understand what mechanism people think would allow for that, but I've had enough debates about it to know that people really think this, even if they can't explain how that would supposedly work.

The reality is actually sort of the opposite of this, however. The price of a stock will tend to increase between the dividend announcement and the ex-date by the amount of the dividend. This isn't just theory, though, research shows this to be the case.

Here's a really simple analogy: Suppose you have the opportunity to buy two artic magenta Stanley travel mugs. You are sure you can flip them for more money in a few days. One of these mugs has a (real) $100 bill in it. The other is empty. In every other way these mugs are exactly the same. How much more should you be willing to pay for the mug containing the money. Based on basic economic logic, you should be willing to pay up to $100 more for it. At any premium less than $100 you should prefer the mug containing the money. At $100, you should be ambivalent. Now, consider a stock right before and ex-div date and the same stock on the ex-div date. Unless something significant happens the eve of the ex-div date, that stock is the same thing on both dates with one exception, when you buy it on the eve of the ex-div date, it comes with a payment. Ignoring taxes and some other confusing factors, a rational investor will be willing to pay exactly that payment more for the stock on the eve of the ex-div date. It's really that simple.

But, of course, there are many other days when you can buy a stock than that. We need a more complicated analogy for that, imagine I had a goose that lays one golden egg every month on the 1st of the month. For simplicity, assume each one is worth $100,000 and the price of gold is fixed. You wish to purchase the goose and we've come to an agreement on a fair price. Now, if you purchase the last day of the current month, you will get 100 grand the next day. If you purchase on the 1st, I get that egg. So, when do we do the deal? Or rather, how do we come to an agreement on when to do the deal? The simple and fair answer is to prorate the value of the next egg and add it to the agreed price. If you buy on the 1st, you pay no premium. If you buy on the last day of the month, you pay an extra $100K. If you buy halfway through the month, the premium is $50K. This is essentially how accrued interest works for bonds. The logic for dividends is the same with the caveat that bond valuation is a much more precise exercise than stock valuation.

The idea that the dividend comes directly out of the price (how?) or that it is pulled from the company's value is really pretty ludicrous. If that were the case, why doesn't the exchange adjust the price after every payroll or capital expenditure? How or why would the dollars spent on the CEO's bonus be different from the dollars paid to investors as dividends? There's no logical basis for that idea and frankly, it strongly suggests a fundamental misunderstanding of stock/company valuation.

To be clear, paying dividends does have a meaningful impact on a company. That's money that can't be used to fund operations or make capital improvements. Some companies take on debt in order to avoid cutting their dividend. All of this is relevant to valuing the company. But it's not a simple subtraction from the price.

Answer 7

This means I would end up paying more tax if I get dividends (as opposed to capital gains).

This very much depends on a country's tax code. For example, in the U.S. dividends can provide a stream of income that is tax free at the federal level for tax payers in certain fairly generous income brackets. From Intuit (my emphasis and bolding):

Ordinary dividends are taxed using the ordinary income tax brackets for tax year 2023. Qualified dividend taxes are usually calculated using the capital gains tax rates. For 2023, qualified dividends may be taxed at 0% if your taxable income falls below:

$44,625 for those filing single or married filing separately,
$59,750 for head of household filers, or
$89,250 for married filing jointly or qualifying widow(er) filing status.

In order to qualify for the 0% tax rate, certain requirements must be met. These are to numerous to list in detail here. To first order there is as minimum holding time for the underlying shares (which may not be part of hedging) and the dividend must be paid by a U.S. company or qualifying foreign company. The conditions are fairly easily met by American long-term retail investors. The applicable tax brackets frequently make this an attractive option for people in retirement that desire a fairly steady and tax-efficient income stream.

Prior to my own retirement, I spent several years slowly transitioning from a mostly growth-oriented stock portfolio to one including many dividend-bearing stocks. Now ten years into retirement I consider this one of my smarter financial moves.

Answer 8

To answer your question concisely:

Yes. It is more tax-inefficient for you, if the company distributes a dividend. Australia is by far not the only country where this happens. The return of capital to shareholders often depends on the maturity of the company. An alternative for the company could be to buy back own shares. A mix of both can be reasonable for a company, again, depending on the circumstances.

Answer 9

What you're witnessing when the share price drops by the dividend amount is a coincidence. The thing to remember about stock price is that they are not the total of the actual assets of the company, but they are what the "perceived" value of the company is by people buying and selling the stock. The reason that the price drops after a dividend is usually because people who are chasing dividends sell these shares and buy shares in another company that has a dividend due. Because they're looking to offload the shares, the price drops.

Similarly, you may see a small spike in your share price in the run up to the dividend date.

This question goes into a load more detail - If stock price drops by the amount of dividend paid, what is the use of a dividend