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Co-authored by Treading Softly.
One of my favorite historical movies, albeit recognizing that it’s not historically accurate, but still historically placed, is “Kingdom of Heaven” by Ridley Scott. Near the end of the movie, Saladin is attacking Jerusalem, and they’re negotiating the surrender of the city to him. One of the defenders, the main character of the film, poses a question about the value of Jerusalem, and we get this exchange:
“Balian de Ibelin: What is Jerusalem worth?
Saladin: *turns from facing his army to look at Bailan* Nothing
Saladin: *walks towards his army*
Saladin: *turns again to face Bailan. Raises his hands and smiles* Everything”
How can a city of such historical importance have no value, but be of utmost value? The question comes into how you value the city itself. The city of Jerusalem is not a massive trade route; it’s just bricks and stones. Yet, when you apply the religious significance of different world-sized religions to Jerusalem, it becomes massively important. The leader of a Muslim empire would want that city because of the religious sites there. Likewise, the Christian Crusaders consistently believed that the city was of utmost importance because of their religious sites and so forth.
You didn’t come to Seeking Alpha for a history lesson about religious significance, but this ties deeply into how you value things. You see, you apply value intrinsically based on your viewpoint, goals, and desires. Dividends can be a very personal subject for many. There have been no less than three articles written recently on Seeking Alpha that simply declare that “dividends don’t matter!” What the author does is that they try to come across as if this is a novel new idea, but ironically, they’re just misapplying a theory that has been around for decades.
So, instead of attacking all the straw men in that article stream, let’s discuss the theory that these articles misapply and how this can be applied to your life.
Let’s dive in!
Dividend Irrelevance Theory
Dividend irrelevance theory was created in 1961 by two future Nobel Prize-winning economists, Merton Miller and Franco Modigliani. At the time the theory was created, they had not yet won their Nobel Prize. Their Nobel Prize was won for their unique methodology of valuing private companies—that’s important, so please note that.
These two gentlemen posited in this Dividend Irrelevance Theory that a company’s dividend should have no impact on its value. This means that when you look at the value of a company’s stock price, the dividend yield should be of no importance to you. The theory further posits that a dividend can be harmful to a company because the company could have spent that money better in other ways, such as growing the company to grow earnings.
The argument for this would be used to say that when a company’s ex-dividend date comes, the share price is adjusted accordingly. So, if you have a $10 per share company that pays out a $1 dividend that quarter, the price on the opening day of the ex-dividend is $9. You’ll have people who misapply this theory say, “Aha, no value was created! It was actually extracted from the company. Look, the share price has changed.”
A proper application of this theory would be that it was the $1 dividend that was paid out. The share price should remain at $10 because the value of the company itself has not intrinsically changed. If the company generated $1 of earnings and then paid all of those earnings out, the company is still worth $10. The argument using dividend irrelevance theory would mean that you should have reinvested that $1 back into the company, thus making the company worth $11 when it’s valued.
There are a few key assumptions here that go into this theorem that really don’t apply when you put it into real life. Consider this: when a company earns a dollar and reinvests that dollar back into the business, rarely does the value of that reinvested money completely add exactly $1 in value to the company itself. When they invest in themselves, you have to then adjust that value for the risk/reward of whatever they’ve decided to invest in or however else the company used that money. We’ve all seen companies squander capital, putting it to uses that reduce shareholder value. We’ve all seen other companies that can put $1 to work and increase value significantly with it.
The other key assumption within dividend relevance theory, when applied to public companies (remember, these guys were specialists in valuing private companies, not public ones) the assumption would be that the market is 100% efficient, meaning that the market will always properly value every company effectively. If you’ve been in the market for any length of time, you realize that the market is rarely efficient, especially in the short term.
Big Issues With This Theory
Looking at the key assumption that this theory is based on, I see some major glaring issues with it that need to be recognized. The first major issue that I recognize is that management teams rarely can effectively reinvest the cash the company has earned in a way that generates strong value changes. This theory believes that the management of the company knows how to spend their money better than you do if you received it as a cash dividend. Consider the companies out there that do not pay out dividends and see if the value of that company rises equivalent to the earnings that they’ve generated.
Let’s use the popular and established Meta Platforms (META) as an example. From January 1st, 2022 to December 31st, 2023, META’s market cap declined 1.3%.
Yet, in that time frame, they generated a net income of $39 billion in 2023 and $23 billion in 2022. Arguably, the value of the company should have risen during that time frame. If we’re using the dividend irrelevance theorem and recognizing that the market should be completely efficient if the company is reinvesting this money back into themselves, the market value should increase as far as the market cap goes. You might ask me, knowing enough about META, you know that they’ve been actively buying back their shares and that their share price value has done well in general. You see, META bought back a combined total of $56 billion worth of shares. So, even factoring in buybacks, which are still an extraction of essentially a value from the overall company, the company’s value still fell.
Let us look at another example with Block (SQ). In August 2021, SQ announced an all-stock acquisition of Afterpay for $29 billion. During the time of the announcement, SQ had a market cap of over $120 billion. The acquisition was completed in January 2022.
It has been over 2.5 years since the acquisition, and SQ currently sports a market cap of $40 billion, or a +65% drop in value.
Do you still believe management knows the best regarding how they can create value for shareholders?
Let’s compare that to a dividend stalwart like Enterprise Products Partners (EPD) over the same period:
During the same period, EPD not only paid out $8.3 billion in distributions to its unit holders but also repurchased hundreds of millions of dollars’ worth of common units. According to the Dividend Irrelevance Theorem, this would mean that we should see a decline in the value of EPD or at least a flattening of its value if its revenue wasn’t higher than what it paid out.
These two companies are only two examples among a sea of possible others that show the issues with blindly accepting the Dividend Irrelevance Theorem.
Dividends: One Of Many Drivers Of Value
Management teams can rarely reinvest earnings so effectively that they can drive immediate value changes in a publicly traded company because the market isn’t 100% efficient. This means that they have to be able to convince the market that their reinvestment of those earnings drives new value that drives demand for the shares.
Secondly, it ignores the fact that dividends can create demand. A company’s market cap or its value as a whole is more driven by the supply and demand of market sentiment than by the earnings of the company or what the company is doing as a whole. We can see companies with massively negative earnings with massive market caps, not because the company itself is tangibly valuable if you were to sell off the individual pieces. Instead, it is because the market has demand for the shares as they trade.
Do dividends create value for many companies? The answer is yes. Not because the dividends themselves generate new earnings for the company or provide new cash on the balance sheet, but because they help create a steady demand for the company’s shares. This can then drive the market cap higher. Often, we see dividend-paying companies take advantage of premium valuations to issue new equity, raising new capital that can then be deployed into new projects.
Consider Realty Income (O):
O is a Dividend Aristocrat REIT with a reputation for increasing its dividend numerous times per year. It fuels its growth primarily by issuing new equity at prices high enough that it can invest the proceeds to generate returns that grow earnings per share. You can see that O’s outstanding shares and dividends per share have grown, along with its total return.
This business model’s success is due to the demand for the shares, which is largely driven by its dividend policy.
It’s important to note that this is not necessarily true for a privately held company where there is no supply and demand for the shares of the company, and there is no easy way to raise new capital. O has an ATM (at-the-market) program in place at all times to sell shares whenever prices are high enough. Raising new capital for a private company is far more expensive and less reliable. A private company is more readily valued based on its tangible pieces. The cash that goes to a dividend in a private company is cash that’s no longer able to be tangibly valued into the company itself. This means that the company’s value should remain static once that cash leaves or would climb if the cash was reinvested. This is why I mentioned so strongly that these two economists were experts at valuing private companies, not publicly traded ones, and that many who misapply their theories miss this entirely.
Does a dividend add value to a publicly traded company? Sometimes yes, sometimes no. If Nvidia (NVDA) decided to end its $0.01/quarter dividend, would the share price collapse? Probably not. Nobody is saying, “Buy NVDA, the dividend is great!” Investors who are choosing to buy NVDA are buying it for other reasons. If O eliminated its dividend, though, the share price would plummet.
Theory vs. Practicality
While I love arguing the finer points of mathematical theories, there’s an enormous difference between a theory of how to value a company and how you run your portfolio and your retirement. Suppose you were to be an ardent believer in Dividend Irrelevance Theory. You should then believe that any company with massive earnings that are reinvesting them should see massive increases in value over time, which we know is not necessarily true. Instead, you need to understand that the Dividend Irrelevance Theory has massive assumptions that help invalidate the impact.
If you want to see the difference between having dividends and not having dividends, just take a look at the chart of the S&P 500 (SPY) over its history. I’ll include it down below for you:
Without the dividends from the SPY, you’d miss out on almost 1000% of returns. If those 1000% returns are irrelevant to you, I would love for you to pass them on to me whenever you get the dividend from your holdings.
So, How Do Dividends Matter To You? Income to Meet Your Needs
So, if we understand the finer points of valuing a company on the market, it is less based on its dividend and more on supply and demand for shares. Ultimately, the biggest factor that influences the share price of a company is how much investors want to own the shares. That demand is often correlated with things like earnings, perception of book value, cash flow, and other factors. The dividend is certainly an attraction for many investors.
What does that mean for you? In all honesty, it means very little because the value of the holdings of your portfolio only matters on the day you buy them and the day you sell. The gyrations of the market that happen every second in between those two moments are, at best, a cloudy crystal ball.
If you need to sell holdings to be able to generate the money you need to live, then the value of your holdings every single day becomes critical. If you sell a share today and its value increases tomorrow, you’ve missed out. Should you hold a share today and its value decreases tomorrow, you might have to sell at a poor price to meet your personal budgetary needs. If you follow a company closely, you likely have a reasonably good guess as to how much in earnings it will generate next quarter. Unfortunately, projecting share prices is not as easy as knowing that a company will generate $X in earnings and the price will therefore go up $Y. You can’t predict with confidence whether the price of any particular stock will be up or down tomorrow.
This is a stress that I try to remove when it comes to portfolio management. When I created my unique Income Method, I created a method that is designed to receive an abundance of dividends from the market as a form of income to pay for your retirement. So, if the value of your shares rises or falls today or tomorrow, it doesn’t matter because the income pouring into your account pays your way, and you don’t have to sell any shares.
Is there value created for you as an individual when you receive a dividend? The answer is yes.
The dividend is a portion of the company’s cash flow. The company generates the cash and pays it to you, as long as the company isn’t selling assets or using debt to fund its dividend, the value of the company remains unchanged. If a company is worth $10 and generates $1 of earnings, which it pays out as a dividend, then the company is still worth $10 at the end of the day, for private companies. For publicly traded companies, the exchanges adjust the trading value to help people realize that the dividend is no longer available, but demand drives daily share price and, thus, value movements.
Just like the city of Jerusalem in the Kingdom of Heaven, the dividend means nothing to some because they view valuing a company differently and don’t want to receive income from the market. They want their cash locked up, often to avoid taxation.
However, for a retiree who lives on a fixed income and Social Security may not be cutting it to pay all their bills, a dividend income stream can mean literally everything. For those who don’t need the cash, the option to reinvest capital into the same business, or into a different opportunity provides a level of flexibility to manage your portfolio allocations and take advantage of the best opportunities available. Some might believe that the management of a company can decide what to do with money better than you can, but I disagree. I’ll decide where the money goes; thank you very much!
That’s the beauty of my Income Method. That’s the beauty of income investing.