In the above example, you would have the same net worth prior to and after the ex-dividend date. However, there is a difference in tax consequences if you held the stock in a taxable account because you would have to pay taxes on the dividend received. Dividends are required to be reported on the federal tax return and possibly on some state tax returns. Even though your net worth appears to be the same before and after the dividend is paid, you actually have less money once you pay the tax. It’s clear to see that you would rather see the company reinvest its profit than pay it out via a dividend. In addition, had you chosen to sell shares to receive cash, you are only paying capital gains taxes, which are typically lower than taxes paid on ordinary income, such as non-qualified dividends. Even if you had to sell shares (as opposed to receiving a dividend in cash), you still come out better after-tax.
MYTH: Dividends are a guaranteed return.
A dividend does not represent the total return of a stock; it is just one component. The stock’s price can also change based on earnings and news related to the company.
Company A (no dividend): Stock makes 20 percent
Company B (with a dividend): Stock loses 10 percent but pays a 5 percent dividend for a return of -5 percent
Which stock makes sense to own in this scenario? Company A, of course. It may feel great that Company B paid you back 5 percent, but at the end of the day, the total return of the stock, which includes both income and price appreciation, is more important. Besides, why would you choose to avoid a stock growing at 20 percent per year just because it didn’t pay a dividend? Isn’t the object to get the best return for the least amount of risk?
Company A (no dividend): Stock makes 20 percent
Company B (with a dividend): Stock makes 15 percent but pays a 5 percent dividend for a return of 20 percent
In the example above, Company B’s stock price did not increase as much as Company A’s stock price because Company B paid out part of its earnings to its shareholders and Company A chose to reinvest its earnings back into the company. An investor could have also sold stock of Company A to accomplish a similar result. One of the possible reasons that investors prefer dividends is that numerous behavioral studies show that investors who sell a stock just prior to a rally feel more regret than those who received a dividend because one act is out of their control (receiving the dividend) while the other is not (selling shares).
Investors also seem to think that a company that pays a dividend is a safer company and that this dividend is guaranteed. Dividend-paying companies are typically more mature and don’t have the need for excess cash, whereas growth companies need a lot of capital and are constantly reinvesting back into the business. Just because a company pays a dividend today does not mean they will pay a dividend next quarter. That dividend can be cut or even eliminated if the business struggles. In 2015, 394 companies trimmed dividends, a 38 percent increase over 2014 according to S&P Dow Jones Indices.