Dividends as a mutation

When I opened my Sharebuilder account the other night, I saw that my portfolio accumulated over $25 in quarterly dividends. Ah, the thrill of free money! Further inflating my sense triumph how I set my Sharebuilder account to free automatic dividend reinvestment—so I got free stocks! But my enthusiasm waned, then completely deflated, after I spent a few hours learning about dividends. Dividends, I learned, do not matter to the small time investor like me. I repeat—they don’t matter, they’re irrelevant, and should not affect your purchasing decisions. In fact, dividends chomp on overall your earnings. Here’s why.




Say you have 10 stocks for corporation X valued at $50 each, for a total value of $500.Consider the following thought exercises:

• Are you thrilled by a stock swap? If the company declares a 2-1 swap, you have 5 stocks valued at $250 each, for a value of $500.

• Are you thrilled if a company offers you stock dividends, wherein every stockholder receives an extra, say 10% share? In this case, you’d have 11 stocks—but because the your overall company ownership percentage remains the same, as both the denominator and numerator become larger. The stock value declines as well—by about 10%. Those 11 stocks have a value of about 4.55 each—and your total value remains $500.

• Are you thrilled if the company offers a mandatory buyback 10% of your shares? The value of company declines by 10%, since the company has to spend the money to purchase the stocks. So you have 9 shares for a total value of $450, but $50 in taxable cash. You can buy back the stock, and you have 10 shares for a value of $500 once again, minus the taxes you have to pay in $50 in capital gains.

Stocks are securities that signify ownership in a corporation and represent a claim on part of the corporation's assets and/ or earnings. When we buy a stock/ share of a company, we are purchasing a cut of future value—prices fluctuate when people speculate about future value. When a corporation issues a dividend, the value of the corporation’s total assets decreases. (Incidentally, the day that a company declares a dividend, it’s said be going x-dividend. On the day the stock goes x-dividend, there’s an “x” by its price on the NYSE to indicate to investors why the price decreased.)

Paying dividends to shareholders, in other words, is the functionally the exact thing as a mandatory buyback of shares. With the dividend reinvestment, I lose no value in my investment, nor do I lose value. In fact, it’s a disadvantage: With my $25 in capital gains, I will be taxed at 15%--in addition to the normal tax I will be charged when I sell my “free” stocks at a future date. If a company reinvested its earnings, like Warren Buffett’s Berkshire Hathaway does, I would not have to pay those taxes.

If dividends are such a tax nuisance, why do corporations issue them and spend so much time on them? Why does Standard and Poor write about its dividend aristocrats? Yale professor Robert Schiller says dividends are best understood in through the lens of behavioral finance: It’s all about investor psychology. Corporations’ boards know that investors interpret dividends as something that healthy, long-lasting companies issue. Former University of Chicago professor Merton Miller called it (not accounting for taxes) a “neutral mutation,” an evolutionary biology term that describes mutations that are neither advantageous nor deleterious--hence the picture of a DNA strain in this post.