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DIVIDENDS ARE a seemingly mundane topic. But like many areas of personal finance, it’s one that still generates debate. The most common question: All else being equal, if one stock pays a dividend and another doesn’t, shouldn’t an investor prefer the one that pays the dividend? We’ll examine this question, and then broaden the lens to look at dividend strategies more generally.
To better understand how dividends work, let’s look at Procter & Gamble. Last year, it generated $84 billion in revenue and $15 billion in profit. This year, it’ll deliver a bit more. With those profits, P&G’s management has a number of options. It could reinvest the money back into the business by, say, building a new production plant. Management could acquire other companies. It could buy back shares. Or it could simply keep that cash in the bank for another day. But if there’s still a substantial amount of cash left over, management could distribute it to shareholders. That’s what a dividend is—a share of a company’s after-tax profits.
In the case of Procter & Gamble, it chose to distribute about 60% of profits, or $9.4 billion, to shareholders this year. Since there are 2.35 billion shares outstanding, that works out to $4 per share. So, in addition to whatever price gains P&G’s stock delivers, shareholders will also receive $4 in cash for each of their shares. It’s this dynamic that often leads investors to ask a question: If P&G shareholders receive that $4 regardless of whether the stock goes up or down, isn’t it preferable to own P&G shares rather than the stock of another company that doesn’t pay a dividend?
To answer this question, let’s consider a thought experiment: Suppose another company was exactly like Procter & Gamble in every way except that it didn’t pay a dividend. What would be the effect? If this alternate company’s business were truly identical, it would be worth exactly the same as P&G, except that it would have an extra $9.4 billion in the bank. The result, then, would be that the alternate company’s value would be higher by $9.4 billion, and that additional value would be reflected in its share price. On a per-share basis, that would be $4, so this other company’s share price would be $4 higher than P&G’s.
What conclusion can we draw from this? What the math tells us is that, from the shareholder’s point of view, it should make no difference whether a company pays a dividend or not. The shareholder receives the same $4 of value either way—as a dividend or in the form of a higher share price.
If that’s the case, why do companies pay dividends? Why wouldn’t they simply hold on to the cash they generate? Many companies do just that. A typical pattern for newly public companies is that they’ll hold on to their profits during their early years, because managers of young companies are happy to reinvest every dollar they can back into their growing business.
But at a certain point, as companies expand and become more profitable, they tend to reach a point where there’s simply too much cash to productively reinvest. While it’s an extreme case, that was the situation at Apple back in 2011. Its cash pile had grown to nearly $100 billion. For a long time, the company felt that it was best to hold onto its cash to preserve flexibility. It was only when activist shareholders began to agitate for the company to do more that it initiated sizable dividend payments. Sharing a modest portion of its cash balances “will not close any doors for us,” CEO Tim Cook said at the time. Faced with the same problem—too much cash with too few ways to use it—tech companies Salesforce and Meta also recently initiated dividends.
This makes sense, but it raises a question: If, according to the math, dividends don’t make shareholders any better off, why are they so popular? For starters, many investors—especially those who are retired—like dividends because they feel like a paycheck. Suppose you held a position in Procter & Gamble and needed cash to meet your monthly expenses. You could sell some of your shares. That isn’t too difficult, but there’s nonetheless an appeal in receiving dividend payments because they don’t require any work at all.
There’s an emotional component, too. As we saw earlier, there’s no mathematical difference between a company that pays a dividend and one that doesn’t. When a company pays a dividend, its share price may dip a bit. But that dip is almost imperceptible to shareholders. By contrast, when an investor has to sell shares, that change is noticeable, even though the difference is only in the optics.
There’s also an element that isn’t simply emotional: Because companies are often hesitant to reduce their dividends, dividend rates tend to be much more stable than share prices. P&G, for example, notes that it has paid a dividend every year for more than a century. Moreover, for 68 years in a row, that dividend has increased. Meanwhile, P&G’s share price has experienced significant ups and downs over the years. For investors drawing on their portfolios, dividends deliver both greater simplicity and greater reliability.
There are other reasons that companies like to pay dividends. Many trusts, for example, prefer stocks that pay dividends because beneficiaries are in many cases limited to the income that the trust generates each year. And whether it’s rational or not, many investors view companies that pay dividends as being higher quality. One popular index is called S&P 500 Dividend Aristocrats. It includes companies that have increased their dividends every year for at least 25 consecutive years. There are also the so-called dividend kings, which have boosted their payout for more than 50 years in a row. Dividends, in other words, have a very positive connotation.
Does that mean you should tilt your portfolio toward higher dividends? Despite the benefits, I don’t recommend it, for two reasons. First is the nature of companies that pay dividends. Because newer companies tend not to pay dividends in their early years, companies without dividends tend to be faster growing, on average. In other words, a portfolio that’s tilted toward dividend-paying companies will end up being tilted toward older, slower-growing companies. For example, Tesla and Netflix don’t pay dividends but have, of course, delivered strong share price gains.
The second reason I don’t recommend going out of your way to hold high-dividend payers is because, all things being equal, dividends are tax-inefficient. If you’re in your working years and have no need for current income from your portfolio, dividend payers—in a taxable account—will only serve to generate more taxable income. Going back to the Procter & Gamble example above, it would be more tax-efficient for the company to not pay its $4 dividend and instead for its share price to be $4 higher.
If you own a diversified fund tracking an index like the S&P 500, it will hold a significant number of dividend-paying companies—including Procter & Gamble—and that’s okay. But I see no need to go out of your way to add individual stocks or funds that specifically favor dividend payers.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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There is nothing wrong to own stocks with nice dividends. Just make sure these are good companies.
Look at Costco stock price and all the dividends they come with……
Corporations have proven to be horribly irresponsible in the use of their excessive cash, with absolutely no regard cor their “owners” their shareholders. Huge CEO salaries ( thousands of times their average worker) with no concern for preformance, excessive fringes, multiple corporate jets, lush meeting locales, and massive stock buybacks ( the latter accounted for 50% of the market’s gains ). Dividends do not eliminate these abuses, but the are at least a bit of a brake, and at
in the case of most of the “Aristocrats” are part of the “corporation culture” and while not guaranteed, are pretty safe.
Mr Grossman should use a few more examples, other than P and G.
While I do not dispute the information in the article, Adam did not address the beauty of compounding—-reinvesting dividends leads to a higher dividend amount and grows the share base—a very powerful and simple financial strategy which allows flexibility in later years to then take the dividend in cash and allowing your principal to remain.
As explained in the article, there is no advantage to having dividends and reinvesting them because the share price goes down when dividends are paid.
Does your advice change if those dividend holdings are in a IRA?
Lower volatility, probably. Easier psychologically – sure. A dividend strategy may be less tax efficient for some people though. Dividends and short-term capital gains are effectively taxed at marginal IT rates, long-term capital gains have a lower tax rate (even zero for some folks). It may be better to sell some shares periodically vs receiving a dividend.
I believe that like long term capital gains, qualified dividends are taxed at 0% or 15% or 20%, not as ordinary income.
Exactly. In our taxable account each year the question is always what percentage of dividends will be ordinary vs. qualified.
Always enjoy Adam’s writing. But the comment that dividend funds are inferior to broader market index funds due to tax inefficiency seems overstated.
I agree high dividend yield funds are tax inefficient, but wouldn’t say that about dividend growth funds. Yes, their dividend is still higher than a total market or S&P 500 index fund, but the difference is very small. (For example a yield of 1.7% for Vanguard Dividend Appreciation VIG versus 1.25% for total market index VTI or 1.26% for S&P 500 index VOO.)
This seems to be a small price for the quality factor mentioned and its lower volatility, especially for a retiree.
Great article as usual, Adam. I would like to add, it is common knowledge that Warren Buffett and Berkshire eschew dividends ( and splits), I believe they paid one dividend, decades ago, though, and that has worked out pretty well!
Buffett eschews paying dividends, but if you look at the publicly traded companies he and his lieutenants invest in for Berkshire, they are often strong dividend payers.
Not questioning your calculation or logic here Adam —
“The result, then, would be that the alternate company’s value would be higher by $9.4 billion, and that additional value would be reflected in its share price. On a per-share basis, that would be $4, so this other company’s share price would be $4 higher than P&G’s”
but couldn’t that extra $4.00 disappear from the stock value based on any number of internal and external events whereas a dividend is either cash in hand or compounded by reinvesting it?
You are looking at a possible future scenario while Adam is looking at company value at a point in time. The $4 could disappear in the future but it could also increase the stock price by more than $4 if, for example, it helps fund a successful innovation.
Absolutely. Look at the S&P500 from 10/1968 – 8/1982 and again from 8/2000 – 10/2013. That’s 25 years out of the last 54 years (almost half) where the S&P500 stock price basicly went sideways before new permanent highs were reached. That’s great for people in their working years who continue to save, thus buying cheap shares. But it’s terrible for anyone entering those periods with a lump sum they want to live on. A person entering those periods with a lump sum and who if they were invested for growth (S&P500) ended up drawing down their nest egg. Conversely, owning good dividends payors would allow someone to live off the dividends. More recently, a dividend ETF like SCHD has paid (on an annual basis) more in dividends each year since 2019 even though it’s share price has fluctuated with the two market pullbacks since then. I think dividends are under appreciated. Part of the problem is possibly that many charting tools default to stock price versus total return, which can paint a very different picture.
Totally. A bird in the investor’s hand is nearly always worth two in the corporate growth promises bush.
Another reason to distribute cash to shareholders is that I can do more with it FOR ME than the company can. As a recent example there’s Apple’s foray into the self-driving car business. They exited after a number of years where the company spent billions and produced…nothing of value. They could have set the money on fire and achieved the same thing. I’d much rather have Apple send that money to shareholders than waste it on unproductive activities that don’t add value, that in fact detract from the company’s value.
I can’t always do something better with a company’s profits than its management can, but the reverse is also true.
Another excellent article! Thank you.
“…dividend rates tend to be much more stable than share prices.” Indeed. That’s attractive when you’re in the drawdown phase of life. Tax concerns about dividends also abate in that phase. Dividend income enables very simple and sustainable income strategies for a widow or spouse whose partner is slowing down. And yes, there are all kinds of psychological benefits from “plucking the fruit while keeping the orchard.”
The S&P 500 is richly priced right now so if you’re buying, you’re buying an historically anemic dividend yield. Value stocks and ex-US stocks still produce a far more compelling yield for every new dollar invested today. Our stock portfolio holds a big portion of the broader stock market, but tilts towards higher ex-US, value, small, and dividend appreciation; all have higher dividend yields than the U.S. S&P 500.
Dividends count as income when calculating IRMAA, no? Even though I’m retired, I would be better off with the share price increasing. Between my pension, my Social Security and my RMDs I do indeed care about taxes, and I also care about IRMAA.
They only count as income if in your taxable accounts.
Thanks to RMDs my taxable account is growing at the expense of my IRAs.
And we hope it keeps growing for many more happy years
What a nice thought! Thank you.