if you're a dividend investor you've no doubt come across people on the internet who question your ability to do simple math the comments that you've undoubtedly heard are dividends aren't free money they come out of the stock price dividends mean the company has no more good growth ideas you don't need dividends you can always just sell shares or over the long term grow stocks are always going to outperform dividend paying value stocks now we'll say there is some truth that's baked into each one of those comments and we're going to go over all that but what people with that perspective fail to realize is that investing is bigger than just simple math but first let's go over the math so that we understand what the argument is and let's start with the classic dividends aren't free money they come out of the stock price now here's how dividends and stock prices work in general let's say a stock is trading for $100 and on October 1st they announce earnings of $5 in excess cash per share they plan to keep $1 in retained earnings to use in the future for the business and they decide that they'll distribute the additional $4 per share as a dividend for shareholders who own the stock on October 11th now it takes 2 to 3 days for stock transactions to clear so let's say the X dividend date is October 9th that means you have to buy the stock by the end of October 8th in order to receive the dividend and how this generally impacts the stock price is that on October 8th the stock should trade for $105 which is basically broken down with future earnings being worth about $100 then they have $1 in new retained earnings and a $4 dividend that's coming to shareholders and then on October 9 9th the stock goes X dividend meaning new shareholders won't receive it and they're not going to pay a premium for a dividend that they're not going to receive so the stock should trade for about $101 which breaks down with future earnings being worth $100 and they still have that $1 of new retained earnings so on that X dividend day the stock price should basically drop the amount of the dividend and of course those are just general numbers there's all kind of variables that impact a stock price whether it's news about the company or other things that make it go up and down but in general this is how the market handles dividends in relation to price so when people say the dividend comes out of the stock price they're right it does it's absolutely not free money it's the earnings that a company generated that they're giving back to its shareholders but that's not the whole story the main difference between a company that pays a dividend and one that doesn't is that the shareholders get to decide how they want to allocate their slice of the profits now here's what I mean so if we have company a which is the one that we just talked about and they made an extra $5 per share they're keeping $1 for the business which we still own shares in and they're giving us $4 for each share that we own to do with whatever we want so if we need to use it as income we can if we want to reinvest in a different opportunity we can do that as well or if we want we can reinvest back into the same company because we believe in it now obviously you will pay tax on that dividend but tax is the price that you pay to have the option to use the profits however you want that's the price of flexibility and then if we have company B that doesn't actually pay a dividend but keeps the full $5 in the business and for future growth prospects you still have a claim on those profits because you're a shareholder but you're trusting the management team to make good decisions in terms of how they allocate those profits so one isn't necessarily better than the other they're just different in terms of who makes the decision on what to do with your slice of the company profits either you or the company now obviously both companies could also do share BuyBacks with the excess profits which benefit shareholders as well by increasing their overall stake in the company and they generally don't have to pay taxes on that either but again share BuyBacks a version of the company making that decision for you and in case you think that share BuyBacks are always better than dividends there are plenty examples where they're not and it really has to do with the price that the company is buying the shares back at and one of the most obvious examples of this was Facebook or meta in 2021 where they did about $40 billion worth of share BuyBacks between April 2021 and January 2022 by far their largest amount of Buybacks in a three-year quarter span ever and it was at prices between $300 to $335 per share and they did that just to watch the stock dip all the way down to $90 per share within the next year and even more recently we talked about Dollar General where they bought back shares in the $200 to $250 range just to watch the stock dip to $109 less than a year later so just like with everything there's nothing that's always good or always better it really depends on each individual situation and whether you want the company to allocate your profits for you or if you want to do it yourself but how about when people say that paying dividends means the company has no more good ideas for growth a company that consistently pays and grows dividends over time is showing a strength and stability of their business model and the ability to generate cash flow for investors it's another measure we can use to determine how reliable or volatile an investment might be and growth investors are going to say exactly because the company doesn't have any more good ideas for growth they're just giving cash back and that means they're going to grow slower and have a lower return over time and if investing was done in a vacuum and all things remained equal then I would probably agree with that but the reality is that it's not done in a vacuum and things are never really equal between companies and just as an extreme example pelaton investors who bought in July of 2021 at $125 per share after they just announced amazing growth of over 2x year-over-year probably don't think all those growth prospects were worth it at least now especially for a company that never made a profit and is currently trading at less than $5 a share just brutal and I know that I'm picking a really extreme example and the reality is a lot more nuanced than that because you can have a company like Google or Amazon or obviously brks your half away and they've never paid a dividend they reinvest profits they buy back shares and they've had amazing growth and success but again it depends on your exact timeline and where each company is at in their story cuz if you take the total return of the past 5 years between the following companies Google Amazon Berkshire haway McDonald's and Starbucks you might be surprised at the results out of the five Google has had the best return out of all of them at 115% which probably isn't much of a surprise but then the next two best performers are the dividend payers McDonald's and Starbucks at 80. 8 6 and Starbucks at 77. 0 n respectively and both of them have outpaced the total return of Berkshire Hathaway and Amazon over the past 5 years so again just because the company retains earnings and has a plan for growth doesn't mean that it's going to materialize in terms of a higher stock price sometimes just having a solid business that generates cash consistently is going to have a better overall return it just depends on each individual business okay but what about the theory that Dividends are unnecessary because investors can just sell shares whenever they need cash and this is one of those things that is technically true like if you have good total returns you have the flexibility to sell shares whenever you want then you can absolutely do that and it works what it means though is that you're more susceptible to Market timing and factors that impact the current stock price which could determine your tax impact how many shares you have to sell or how much money you'll be able to access at any one time and one of the great things about dividend stocks is you can plan for the future as to what your cash flows are going to be especially if you're investing in stocks that consistently pay and grow their dividends so while stock prices go up and down you know that your cash flow coming in is likely to stay steady or even grow regardless of what the market is doing in any given month or year plus being able to plan your cash flows in advance means you can adjust to complement your income needs without being dependent on a a certain stock price at the time that you need your money and I view investing in dividend companies like having a true business owner mindset because you've invested in a company and they're paying you part of the profit so owning Starbucks is like being a part owner of a coffee shop or owning Valero is like being a part owner of an energy company but I don't have to sell my shares to realize income from that ownership stake because they're paying me in cash every quarter there's nothing wrong with selling your shares whenever you think is best if you don't like dividends but it does add additional variability into your process that you have to manage an account for and a slightly different mindset and that just might not be the right thing for everybody okay but what about the claim that over the long term grow stocks are going to always outperform dividend paying value stocks so obviously we've already talked about this on an individual stock basis and it's really going to depend on each individual company that you're looking at so it's impossible to answer from that perspective and even if you're talking about a group of individual stocks it's really going to be highly dependent on how well the companies are that you pick end up doing but I think it's only fair to look at it from a general growth index versus a dividend index to see how they perform differently over time so I decided to use the following three Vanguard funds or ETFs vix vanguard's growth Index Fund viig vanguard's dividend appreciation index ETF and VM vanguard's high yield dividend ETF and I used ETS for two and a fund for one just so that I can get the most historical data to be able to compare the three and I was able to get up until January 2007 so a little over 25 years of data and if you look at the performance over that time there is no question that the growth fund perform better with an overall average of 11.
37% compound annual growth rate compared to 99. 07% for the dividend appreciation ETF and 7. 77% for the high dividend yield ETF now part of that in theory is that it's kind of designed to do that I mean the growth fund is called growth for a reason plus from a macro perspective we had multiple zero interest rate time frames in this 25e period to where if you look at the data we only had about four or 5 years in that 26e period where the federal funds rate was higher than 0.
