I wasn’t an early convert to the merits of dividend investing. A very good friend of mine, a dedicated and vocal dividend investor, needed years to convince me of the benefits and reasons for using dividend investing as a core part of my passive income strategy. And that was after spending tens of hours discussing it. Why?
Dividend Payments Are (In Theory) Irrelevant
That’s clearly what I learned in school. If you have a corporation that holds $100 and 10 shares, the “value” of each share is $10 (assuming nothing else exists in that corporation). Now, what happens if the company pays out $10 in dividends?
Every share will pay $1.
The company will have $90, which is $9/share.
So, the shareholder received $1 and holds something worth $9. Nothing magical about it? And this theory has merit. It is known as the Modigliani–Miller theorem, and the two men behind it are Nobel laureates.
Wait.. It Gets Worse
When you consider taxes, it’s hard to argue that dividends are a good thing. In that example, the investor will pay taxes on that $1 (except if it’s in a registered account), so the investor will actually end up with less than $10 in value. Given how capital gains are taxed (at a lower rate) and the fact that this could make investors pay taxes years before they need to, it’s not ideal. It would be better to keep all money in the market.
So, Are Dividends… Bad?
You could clearly come to the conclusion that you should avoid dividend stocks at all costs, given all these arguments. But over the years, I’ve personally been convinced that dividend investing is a great investing style for two main reasons:
Dividend-paying companies have better discipline and outperform: The results by these companies have been solid for decades, and I’d argue that managing operations efficiently to pay shareholders is a great incentive to avoid waste and be efficient. It creates a clear metric by which they can be judged: How much free cash flow can you generate and pay back to your shareholders?
Dividend Investing Provides A Framework: I think investing can be so complex and challenging that dividend investing, especially if focused on dividend growth, can provide a great framework. There are thousands of stocks, options, bonds, penny stocks, meme stocks, and so much more. What is the best way to be disciplined and acquire good long-term companies? I’d argue that focusing on companies that have a history of paying and increasing their dividends is a great way to have long-term success while investing.
So yes it took several years but I did end up being convinced of the merits of dividend investing and it is a core part of my passive income strategy.