The Myth of Dividend "Yields"
Stock dividends are periodic (regular or irregular) cash distributions to stock holders by the company. In some less common cases, the distribution can be in the form of stock (in shares) rather than cash. The amount distributed each time is typically small. For companies that distribute regular cash dividends (in the US, the frequency is typically quarterly), the annual dividends amount to about 2-4% of the stock value. But there are cases when the company is involved in a merger/acquisition/spin-off, such as the AT&T spin-off of the AT&T Wireless business; or a company distributes one time dividends to reduce its cash hoard (such as the one time $3.08 dividend by Microsoft in November 2004).
Extra Cash, No Extra Value
By the nature of dividends, it appears to stock investors that dividends are some "extra" cash they earn besides the holding of the stock asset. In fact, stock dividends are called "yields" in the similar parlance as bonds and cash, giving people an impression that dividends are similar to interest payments that "yield" from the bond or cash asset (so the stock can "yield" some cash in the form of dividends). That's quite an unfortunate and misleading name that gives investors a false sense of security. This article is to debunk this most common misunderstanding (and promoted myth) in stock investment. In fact, many analysts take dividend yield as one of the important criteria for picking stocks.
Dividend distribution has absolutely no impact (positive or negative) on investors' returns. On the date when the dividend distribution goes into effect (called the Ex-Dividend date, the date when the stock is traded without the dividends), the stock price should automatically drop by the exact amount of the dividend just distributed when the stock market opened. For investors, the equity value becomes the cash value (as distributed dividend) + equity with less value. The net value change before and after the distribution is zero. In other words, dividends distribution is exactly the same as if the investors had sold part of stocks.
But if you sell part of the stock, you have less shares, while with a dividend, there is no change in the number of shares you own. So isn't that a huge difference? That's a common illusion among investors -- it really doesn't matter how many shares one owns, what matter is the value of the equity, which is the shares times the equity price. In dividend distribution, there is no change in total value, even though there is no change in equity shares owned. Thus a 4% dividend yield stock does not mean you will have 4% returns. If there is no capital appreciation or depreciation, a 4% yield stock will give you 0% return.
Then how about comparing to bonds or cash? Don't they both distribute interests (as cash) in a similar way? How can a 8% yield bond or bank deposit give the investor 8% returns?
For cash deposits or private notes (bonds that can be purchased only at the time of issuance), there is no price drop at the time of distribution, thus it is easy to understand that bond and cash yields are real yields that are different from the stock "yields". For real yields, yield rate = return rate. But with public traded bonds that have regular distribution, there will be a price drop at distribution just like stock ExDiv so that no price arbitrage is possible, nevertheless this does not affect the yield. For the public traded bonds still the yield is a real yield (the underlying logic is the same as the case of private notes mentioned above).
What's the difference between bond/cash yield and stock "yield"? For the former, there is a guarantee for the asset price at the time of redemption, ie, the face value. For example, you buy $1000 6% yield 2-year maturity bond, that means you will have $120 of distributed cash, and at the time of maturity, you can redeem the bond for $1000. Obviously, for stocks there is no such guarantee for the stock prices at all. There is no such thing as "face value" for stocks.
Balance Sheet Differences
But for companies that distribute dividends, doesn't it work in the same way whether it is a bond distribution or a stock distribution, the cash comes out of the company's coffer? Yes, they are identical in the cash flow part. But on the balance sheet, cash coming out of the company does not mean it will increase the shareholder's net equity value. For stock dividend distributions in the company's balance sheet, the cash hoard ("asset") is reduced, thus there is a reduction in equity value (the book value) for the shareholders (there is no change in the liability part of the balance sheet). For bond distributions, the cash hoard is reduced, while the debt liability remains unchanged (the face value of the bond remain unchanged), resulting also in reduction in net value (while for bond holder, there is a net increase in value). In both cases, there is no separate entry on the balance sheet to indicate the amount of dividend or interest payments, and the reduction in equity is due to the reduction in the "retained earnings" entry for the shareholders -- since the company uses up some cash from income, the retained earnings are reduced.
For stock repurchase, there is a little difference in the number juggling, but the end result is the same (reduction in book value). The repurchased stocks are entered as "Treasury Stocks" in the "shareholder's equity" area on the balance sheet, as a negative number. Naturally the cash in the asset is also reduced correspondingly. Behind the balance sheet, the number of shares outstanding should be reduced since the company buys back its own stock (or the company can keep the shares outstanding unchanged with the intention to sell these repurchased shares -- or "treasury stocks" -- back on the market at a later time). In any cases, the end result is still a reduction in shareholder equity (book value).
To sum it up, if a company presents the balance sheet before and after the dividend distribution or bond interest payment, or stock repurchase, there should be a reduction in shareholders' equity (net equity value). The more the company pays dividends or buyback stock, the less the stock holders' equity on the balance sheet become. This is due to the convention that on the balance sheet, shareholder's equity value has nothing to do with the market price of the company equity (stock). In a sense, this is a reflection of the fact that the company has nothing to do with the market price of the stock, while the company has to back up the liability of its bonds.
Dividend Yield and Stock Volatility
Dividend distribution is offset by the stock price drop on Ex-Dividend date, resulting in no net returns, but for the long term, is it possible that stock will climb back to erase the drop caused by the distribution, thus making dividend distribution more like bond yield, at least statistically speaking?
The typical dividend yield is small when comparing with stock volatility. For the SP500 stocks that distribute dividends, the average annual yield rate is 2.1%, while the average volatility of the same group of stocks is an annualized 22%, or about 1.36% per day. In other words, the annual dividend yields on average are about the same amount as the stock daily fluctuations; or, for dividends distributed quarterly, the price drop at Ex-Dividend date is about 1/3 or 1/2 of typical stock daily fluctuations. Another way of saying it, is in considering the typical volatility of equity prices, the dividend yield is insignificant. For the wishful thinking that the ExDiv drops will be erased overall in the long term, note that with the annual stock fluctuation rate of 22%, trying to pick a trend off the 2.1% move is statistically meaningless.
Dividend Distribution is A Liquidity Event
You may still be unconvinced that dividends have no value for investors -- how can it not be good, if I get some extra cash, while in the mean time still owning the same number of shares? Besides, historically dividends are such an important part of returns for investors who invest in the private companies. Compare these two cases: you have the opportunity to invest in two private banks that run identical businesses, one distributes dividends regularly, the other never pays dividends. Obviously the first one is more attractive. You get a way of cashing out some of the returns, even though they both have the same intrinsic returns in equity value, and such returns may be higher than the dividend yield (of the first company).
What's liquidity? Liquidity is the ability of an asset to convert its value to cash. For example, a publicly traded stock can be sold and its value is converted into cash at any time as long as the stock is trading on the exchange. Thus publicly traded stocks have good liquidity. On the other hand, an art master piece may have high value but at the time when the owner want to realize such value, there may not be a market ready for him to sell the art piece to. Such asset obviously has poor liquidity. A liquidity event is a transaction that converts certain non-cash asset into cash. Thus liquidity event does not cause change in value (no profit/loss) except it may incur some transaction cost (such as commissions).
In the above example, pirvate businesses have poor liquidity in equity value since there is no easy market for the owner to convert the ownership into cash. Dividend distributions provide one small window for liquidity, thus it is valuable. However, for publicly traded companies, such liquidity from dividend distribution has no added value at all since the equity value itself is totally liquid in the marketplace, there is no difference between the extra liquidity from dividend distribution and the market liquidity of the equity itself. The cash from dividend distribution is exactly the same as the cash from selling shares in the market.
In fact, any investor can create quarterly dividends for any stocks of any public traded company that does not distribute dividends. All he needs to do is, at every quarter sells a certain fixed cash value (not fixed number of shares) of stock. The net result in returns for investors is exactly the same as if that company would distribute quarterly dividends.
Some people may still not buy such an argument: dividend distributions take cash away from the company's coffer, so it has economic impact for the company, thus there is be a net impact on the investors too, rather than a pointless liquidity event. First of all, when one uses cash to buy stock, the cash asset becomes equity, there is no net change in asset value. When a company distributes dividends, it converts portion of retained earnings into cash, while for stock repurchase, company converts part of retained earnings into treasury stocks. In both cases, there is a definite buyer opposite to investors that has committed cash to buy certain amount of equity. In comparison, if investors sell stocks, the opposite side is unknown but in a liquid market, the investor doesn't need to care who is on the other side of the trade. Coming back to the case of private companies or illiquid assets: since there is no ready buyers of the company equity at the time when the investors want to sell, thus the dividend events make the company itself as the only regular (partial) liquidity provider for the investors, which obviously is meaningful for investors. On the other hand, in a liquid public market, the company is one of the millions of buyers, and thus there is no particular significance for investors that their equities are being purchased by the company (through dividends or through share buyback), or by some other unknown parties.
While quarterly dividends distributions are usually well anticipated in the market and has no surprise to investors, the announcement from the companies of 1) dividend raise or 2) stock repurchase may typically be a positive surprise for the market and may see the equity price jump at the announcement due to the speculation; but such changes does not indicate any changes in returns, rather than it represents a liquidity event or a newsworth event that can move the market, just like the news of a big buyer in the market can push the stock higher momentarily.
In summary, 1) stock dividend distribution = company stock repurchase = investor partially selling shares to raise cash. 2) Dividend yield has nothing to do with equity investment returns. So what about the equity valuation theory that uses the dividend discount model (DDM) to estimate the current equity valuation? Isn't that using a liquidity event that has no relationship to equity value to construct an equity valuation model, in another word, totally voodoo science? Yes, I believe so. Though it is forgivable that it was a 1930s theory, unfortunately it has gained a new following in recent years, and as many analysts have been pulling investors' attention to dividend stocks all these years, the misconception of dividend as "yield" seems deep rooted. No matter how analysts promote it, dividends seem to be candies to help analysts or companies to sell shares, but there are no "fundamental" wealth benefits for investors. Dividends and stock buybacks represent big buyers of stocks in the market. Just like big buyers or sellers from big funds can bring significant liquidity and movements to the market, but it is just a liquidity event after all.
Postscript: Dividends and Options
Though I argue in this article that dividends have given investors no added value at all, dividends are a very important factor in option pricing. Why? By the contract term of equity options, the options give the holder the right to buy or sell stock at a set price ("strike") at or before a set date ("expiration date"). It says nothing of the dividend distribution during the life time of the option. The stock price drop at the ExDiv date becomes the preset event (rather than a stochastic event) that will impact the option pricing in a definite way. When dividends changes, the impact on the option prices are:
Typically companies issues quarterly dividends that are predictable. The future dividend stream is projected into the option prices, so that at the option distribution dates (ExDiv date) there is no price jump or arbitrage opportunity for options, except in one case that requires judgment on "early exercise". Such a situation will be discussed in a separate article.
In general, dividend distribution will not cause any net value jump, either for stock holders or for option holders. Stock holders can totally ignore the dividend amount, because no matter what amount, there is no change in net value; while for options, the complications of dividends arise in two areas: 1) Future dividend stream needs to be projected correctly, otherwise, the option may be mispriced and become the target of arbitrage; 2) On the trading date before the ExDiv date, call option holders need to make a judgment for any in-the-money calls to decide whether to exercise early. Failure to do that, which can actually happen in the marketplace at substantial percentage, presents an arbitrage opportunity.
When stock holders notice the option traders paying so much attention to dividends, it doesn't mean dividends are of any importance to stock investments. In fact stock investors should just ignore dividends.
[References]
Some media articles/web sites promoting the dividend myth:
Pave the Road to Retirement With Dividends - Motley Fool.
Dividend Discount Model.
(The author can be contacted at huangxinw@gmail.com.)
Extra Cash, No Extra Value
By the nature of dividends, it appears to stock investors that dividends are some "extra" cash they earn besides the holding of the stock asset. In fact, stock dividends are called "yields" in the similar parlance as bonds and cash, giving people an impression that dividends are similar to interest payments that "yield" from the bond or cash asset (so the stock can "yield" some cash in the form of dividends). That's quite an unfortunate and misleading name that gives investors a false sense of security. This article is to debunk this most common misunderstanding (and promoted myth) in stock investment. In fact, many analysts take dividend yield as one of the important criteria for picking stocks.
Dividend distribution has absolutely no impact (positive or negative) on investors' returns. On the date when the dividend distribution goes into effect (called the Ex-Dividend date, the date when the stock is traded without the dividends), the stock price should automatically drop by the exact amount of the dividend just distributed when the stock market opened. For investors, the equity value becomes the cash value (as distributed dividend) + equity with less value. The net value change before and after the distribution is zero. In other words, dividends distribution is exactly the same as if the investors had sold part of stocks.
But if you sell part of the stock, you have less shares, while with a dividend, there is no change in the number of shares you own. So isn't that a huge difference? That's a common illusion among investors -- it really doesn't matter how many shares one owns, what matter is the value of the equity, which is the shares times the equity price. In dividend distribution, there is no change in total value, even though there is no change in equity shares owned. Thus a 4% dividend yield stock does not mean you will have 4% returns. If there is no capital appreciation or depreciation, a 4% yield stock will give you 0% return.
Then how about comparing to bonds or cash? Don't they both distribute interests (as cash) in a similar way? How can a 8% yield bond or bank deposit give the investor 8% returns?
For cash deposits or private notes (bonds that can be purchased only at the time of issuance), there is no price drop at the time of distribution, thus it is easy to understand that bond and cash yields are real yields that are different from the stock "yields". For real yields, yield rate = return rate. But with public traded bonds that have regular distribution, there will be a price drop at distribution just like stock ExDiv so that no price arbitrage is possible, nevertheless this does not affect the yield. For the public traded bonds still the yield is a real yield (the underlying logic is the same as the case of private notes mentioned above).
What's the difference between bond/cash yield and stock "yield"? For the former, there is a guarantee for the asset price at the time of redemption, ie, the face value. For example, you buy $1000 6% yield 2-year maturity bond, that means you will have $120 of distributed cash, and at the time of maturity, you can redeem the bond for $1000. Obviously, for stocks there is no such guarantee for the stock prices at all. There is no such thing as "face value" for stocks.
Balance Sheet Differences
But for companies that distribute dividends, doesn't it work in the same way whether it is a bond distribution or a stock distribution, the cash comes out of the company's coffer? Yes, they are identical in the cash flow part. But on the balance sheet, cash coming out of the company does not mean it will increase the shareholder's net equity value. For stock dividend distributions in the company's balance sheet, the cash hoard ("asset") is reduced, thus there is a reduction in equity value (the book value) for the shareholders (there is no change in the liability part of the balance sheet). For bond distributions, the cash hoard is reduced, while the debt liability remains unchanged (the face value of the bond remain unchanged), resulting also in reduction in net value (while for bond holder, there is a net increase in value). In both cases, there is no separate entry on the balance sheet to indicate the amount of dividend or interest payments, and the reduction in equity is due to the reduction in the "retained earnings" entry for the shareholders -- since the company uses up some cash from income, the retained earnings are reduced.
For stock repurchase, there is a little difference in the number juggling, but the end result is the same (reduction in book value). The repurchased stocks are entered as "Treasury Stocks" in the "shareholder's equity" area on the balance sheet, as a negative number. Naturally the cash in the asset is also reduced correspondingly. Behind the balance sheet, the number of shares outstanding should be reduced since the company buys back its own stock (or the company can keep the shares outstanding unchanged with the intention to sell these repurchased shares -- or "treasury stocks" -- back on the market at a later time). In any cases, the end result is still a reduction in shareholder equity (book value).
To sum it up, if a company presents the balance sheet before and after the dividend distribution or bond interest payment, or stock repurchase, there should be a reduction in shareholders' equity (net equity value). The more the company pays dividends or buyback stock, the less the stock holders' equity on the balance sheet become. This is due to the convention that on the balance sheet, shareholder's equity value has nothing to do with the market price of the company equity (stock). In a sense, this is a reflection of the fact that the company has nothing to do with the market price of the stock, while the company has to back up the liability of its bonds.
Dividend Yield and Stock Volatility
Dividend distribution is offset by the stock price drop on Ex-Dividend date, resulting in no net returns, but for the long term, is it possible that stock will climb back to erase the drop caused by the distribution, thus making dividend distribution more like bond yield, at least statistically speaking?
The typical dividend yield is small when comparing with stock volatility. For the SP500 stocks that distribute dividends, the average annual yield rate is 2.1%, while the average volatility of the same group of stocks is an annualized 22%, or about 1.36% per day. In other words, the annual dividend yields on average are about the same amount as the stock daily fluctuations; or, for dividends distributed quarterly, the price drop at Ex-Dividend date is about 1/3 or 1/2 of typical stock daily fluctuations. Another way of saying it, is in considering the typical volatility of equity prices, the dividend yield is insignificant. For the wishful thinking that the ExDiv drops will be erased overall in the long term, note that with the annual stock fluctuation rate of 22%, trying to pick a trend off the 2.1% move is statistically meaningless.
Dividend Distribution is A Liquidity Event
You may still be unconvinced that dividends have no value for investors -- how can it not be good, if I get some extra cash, while in the mean time still owning the same number of shares? Besides, historically dividends are such an important part of returns for investors who invest in the private companies. Compare these two cases: you have the opportunity to invest in two private banks that run identical businesses, one distributes dividends regularly, the other never pays dividends. Obviously the first one is more attractive. You get a way of cashing out some of the returns, even though they both have the same intrinsic returns in equity value, and such returns may be higher than the dividend yield (of the first company).
What's liquidity? Liquidity is the ability of an asset to convert its value to cash. For example, a publicly traded stock can be sold and its value is converted into cash at any time as long as the stock is trading on the exchange. Thus publicly traded stocks have good liquidity. On the other hand, an art master piece may have high value but at the time when the owner want to realize such value, there may not be a market ready for him to sell the art piece to. Such asset obviously has poor liquidity. A liquidity event is a transaction that converts certain non-cash asset into cash. Thus liquidity event does not cause change in value (no profit/loss) except it may incur some transaction cost (such as commissions).
In the above example, pirvate businesses have poor liquidity in equity value since there is no easy market for the owner to convert the ownership into cash. Dividend distributions provide one small window for liquidity, thus it is valuable. However, for publicly traded companies, such liquidity from dividend distribution has no added value at all since the equity value itself is totally liquid in the marketplace, there is no difference between the extra liquidity from dividend distribution and the market liquidity of the equity itself. The cash from dividend distribution is exactly the same as the cash from selling shares in the market.
In fact, any investor can create quarterly dividends for any stocks of any public traded company that does not distribute dividends. All he needs to do is, at every quarter sells a certain fixed cash value (not fixed number of shares) of stock. The net result in returns for investors is exactly the same as if that company would distribute quarterly dividends.
Some people may still not buy such an argument: dividend distributions take cash away from the company's coffer, so it has economic impact for the company, thus there is be a net impact on the investors too, rather than a pointless liquidity event. First of all, when one uses cash to buy stock, the cash asset becomes equity, there is no net change in asset value. When a company distributes dividends, it converts portion of retained earnings into cash, while for stock repurchase, company converts part of retained earnings into treasury stocks. In both cases, there is a definite buyer opposite to investors that has committed cash to buy certain amount of equity. In comparison, if investors sell stocks, the opposite side is unknown but in a liquid market, the investor doesn't need to care who is on the other side of the trade. Coming back to the case of private companies or illiquid assets: since there is no ready buyers of the company equity at the time when the investors want to sell, thus the dividend events make the company itself as the only regular (partial) liquidity provider for the investors, which obviously is meaningful for investors. On the other hand, in a liquid public market, the company is one of the millions of buyers, and thus there is no particular significance for investors that their equities are being purchased by the company (through dividends or through share buyback), or by some other unknown parties.
While quarterly dividends distributions are usually well anticipated in the market and has no surprise to investors, the announcement from the companies of 1) dividend raise or 2) stock repurchase may typically be a positive surprise for the market and may see the equity price jump at the announcement due to the speculation; but such changes does not indicate any changes in returns, rather than it represents a liquidity event or a newsworth event that can move the market, just like the news of a big buyer in the market can push the stock higher momentarily.
In summary, 1) stock dividend distribution = company stock repurchase = investor partially selling shares to raise cash. 2) Dividend yield has nothing to do with equity investment returns. So what about the equity valuation theory that uses the dividend discount model (DDM) to estimate the current equity valuation? Isn't that using a liquidity event that has no relationship to equity value to construct an equity valuation model, in another word, totally voodoo science? Yes, I believe so. Though it is forgivable that it was a 1930s theory, unfortunately it has gained a new following in recent years, and as many analysts have been pulling investors' attention to dividend stocks all these years, the misconception of dividend as "yield" seems deep rooted. No matter how analysts promote it, dividends seem to be candies to help analysts or companies to sell shares, but there are no "fundamental" wealth benefits for investors. Dividends and stock buybacks represent big buyers of stocks in the market. Just like big buyers or sellers from big funds can bring significant liquidity and movements to the market, but it is just a liquidity event after all.
Postscript: Dividends and Options
Though I argue in this article that dividends have given investors no added value at all, dividends are a very important factor in option pricing. Why? By the contract term of equity options, the options give the holder the right to buy or sell stock at a set price ("strike") at or before a set date ("expiration date"). It says nothing of the dividend distribution during the life time of the option. The stock price drop at the ExDiv date becomes the preset event (rather than a stochastic event) that will impact the option pricing in a definite way. When dividends changes, the impact on the option prices are:
Dividend Change | Call Price | Put Price |
Increase | Drop | Increase |
Decrease | Increase | Drop |
Typically companies issues quarterly dividends that are predictable. The future dividend stream is projected into the option prices, so that at the option distribution dates (ExDiv date) there is no price jump or arbitrage opportunity for options, except in one case that requires judgment on "early exercise". Such a situation will be discussed in a separate article.
In general, dividend distribution will not cause any net value jump, either for stock holders or for option holders. Stock holders can totally ignore the dividend amount, because no matter what amount, there is no change in net value; while for options, the complications of dividends arise in two areas: 1) Future dividend stream needs to be projected correctly, otherwise, the option may be mispriced and become the target of arbitrage; 2) On the trading date before the ExDiv date, call option holders need to make a judgment for any in-the-money calls to decide whether to exercise early. Failure to do that, which can actually happen in the marketplace at substantial percentage, presents an arbitrage opportunity.
When stock holders notice the option traders paying so much attention to dividends, it doesn't mean dividends are of any importance to stock investments. In fact stock investors should just ignore dividends.
[References]
Some media articles/web sites promoting the dividend myth:
Pave the Road to Retirement With Dividends - Motley Fool.
Dividend Discount Model.
(The author can be contacted at huangxinw@gmail.com.)
© 2006-2009 by Huangxin Wang 王璜鑫
