Dividends are a seemingly mundane topic, but like many areas in personal finance, it’s a topic that nonetheless generates debate. The most common question is: All else being equal, if one stock pays a dividend, and another does not, then shouldn’t an investor prefer the one that pays the dividend? We’ll examine this question, then broaden the lens to look at dividend strategies more generally.
To better understand how dividends work, let’s look at a company like 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. They could reinvest it back into the business, building a new production plant, for example. They could acquire other companies, which they often do. They could buy back shares. Or they could simply keep that cash in the bank for another day. But if there’s still a substantial amount of cash left over, they can distribute it out to shareholders. And 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 the stock of another company that doesn’t offer a dividend?
To answer this question, let’s consider a thought experiment: Suppose there were another company that 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 mathematically, 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. In other words, the shareholder is economically no better off either way.
If it makes no difference, then why do companies even pay dividends? Why wouldn’t they simply hold on to the cash they generate? This actually is the case for many companies. A typical pattern for newly public companies is that they hold on to their profits during their early years, because managers of young companies are happy to reinvest every dollar they can back into growing their businesses.
But at a certain point, as companies grow 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’s the situation Apple found itself in back in 2011. Its cash pile had grown to nearly $100 billion. For a long time, the company felt that it was the right thing to hold onto this 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, then why are they so popular? There are a few reasons: 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. In 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, and for 68 years in a row, the dividend has increased. In contrast, P&G’s share price has experienced significant ups and downs over the years. So for investors drawing on their portfolios, dividends deliver both greater simplicity and greater reliability.
There are other reasons that companies like to pay out 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 the Dividend Aristocrats. It includes companies that have increased their dividends every year for at least 25 consecutive years. Another is the Dividend Kings. Dividends, in other words, have a very positive connotation.
Does that mean you should tilt your portfolio toward higher dividends? Despite some of the benefits, I don’t recommend it. That’s 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 that don’t pay 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. Tesla and Netflix, for example, 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, then dividends—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 if you’re thinking of adding individual stocks or funds that specifically favor dividend-payers, I see no need to do so.
