Dividends? They Don't Matter

Many investors swear that dividend yielding stocks are better investments than other stocks. Some fellow personal finance bloggers like the Div Guy believe in dividends so much that they dedicate their entire blog, not to mention their investment strategy, to the idea that dividend stocks are simply superior. This idea does not make any economic sense to me, and here's why:

Money is money - the value of shares is determined by the value of a company's income stream and the value of its assets - which includes its cash hoard. A company that pays out $1 in dividends now has 1 fewer dollars in its bank account, and therefore the value of its shares should decline accordingly. As an investor, it should not matter to you whether you have received a payment of $1 from the company, or whether the company keeps that $1 and your stock is now worth an extra buck. Money is money, wherever you hold it. Claiming that dividends create money is equivalent to saying that using an ATM to withdraw money from your bank account somehow makes your over all net worth improve... all you did is simply move the money somewhere else.

Taxes - dividends are subject to tax. When a company pays you a dividend, it automatically triggers a tax liability for you. Unless the dividend is being paid into a tax sheltered account, you would have been better off keeping that money in the company and having it compound without taxation until such time that you decided to sell your stock.

Liquidity? No Thanks - Some say that a company generates liquidity for its shareholders by paying them dividends. Shareholders can hold onto the same number of shares and get some of their money out of the company. But why is that a good thing? If I want liquidity, I can sell some of my shares myself, without the company deciding how much and when to make me liquidate.

Efficiency? I don't Think So - a common claim is that by paying out dividends, management in a company is not tempted to use its extra cash on non-productive investments or waste the money. Well, maybe, but if they have extra cash on hand, couldn't they achieve the same objective without creating a tax liability for investors by purchasing back some of their own shares? That would make share prices go up. On the flip side, what about companies who could use the cash they pay out to make some wise investments, but instead pay dividends and then borrow money or sell more stock to support their investment objectives? That's a worse proposition for the company who will now pay interest expenses or share its income with more shareholders.

Nope. This whole idea of dividends simply does not make sense in a highly liquid market. Now before you wag your finger at me and say that I don't know what I am talking about, I did not invent these arguments. These are arguments that I have been taught in business school finance classes and in my corporate law courses in law school. Not enough for you? Someone actually won a Nobel Prize for making these claims - you can read more about the Modigliani-Miller Theorem for yourself. If you are interested in more reading on the subject, see this easy to understand short paper by a Chicago Graduate School of Business professor. This paper also explains why folks make the mistake of believing that dividends actually do matter.

Now, having picked a fight with a bunch of well respected bloggers, let me stand back and wait for the angry mob to assemble its responses in the comment section... Let the battle begin.