Dividend distributions are an attractive proposition for many investors. As the old saying goes, “a bird in hand is worth two in the bush.” This speaks to the risk-averse nature exhibited by most people. This is rational as it makes perfect sense to prefer a certain outcome to an uncertain outcome with the same expected value.
Consider the following two scenarios:
1) You are offered $100.
2) You are offered an opportunity to flip a coin. If the coin lands on tails you win $150, but if it lands on heads you only win $50. Since there is an equal probability of the coin landing on heads or tails (ie. 0.50), the expected value of the flip is $100 ((0.5)($150) + (0.50)($50) = $75 + $25).
Which scenario would you prefer?
I would guess that most of you would gladly accept the $100 offered in scenario 1 as it offers the same expected value with less risk.
However, if scenario 2 instead offered you $155 when the coin lands on tails, and $55 when the coin lands on heads, then the expected value is now $105 ((0.5)($155) + (0.50)($55) = $77.5 + $27.5). Therefore, you are compensated slightly for accepting the additional risk.
Some people who originally chose scenario 1 would now choose scenario 2, finding the additional compensation adequate. Others would still choose scenario 1, finding the additional compensation inadequate. Either way, I believe that this illustrates the attractiveness of dividends to the risk-averse investor.
However, to me it is not logical to base my investment decision on the dividend offered by a company on their common stock.
Assuming that a company is and will continue to be a going concern, its stock can be classified as a form of perpetuity, in that it theoretically generates cash flows forever. As a result, it is subject to a high degree of uncertainty as its value today is dependent on its cash flows infinitely into the future. The further into the future we go, the more uncertainty we encounter as to the existence and/or amount of those cash flows that will be received.
Therefore, anyone interested in investing in such a high risk security must be able to withstand a high degree of volatility. This, in my opinion defines a long-term investor. By extension, a long-term investor will not require an income from his/her long-term investments. If he/she does require an income from his her long-term investments, then he/she is not really a long-term investor, but rather a short-term investor in that they need their money in the “short-term”.
Now, to clarify this point somewhat I will say this. Most people are both short-term and long-term investors. That said, there is a simple way in which to account for this. Allocate an adequate amount to cover your income requirements next year in a short-term discount bond with a maturity of one year. Allocate an adequate amount to cover your income requirements two years from now in a short-term discount bond with a maturity of two years. Continue this trend until you reach approximately 15 to 20 years in the future where you are fully able to absorb the inherent volatility associated with long-term investments.
If you happen to invest in a coupon bond that pays fixed semi-annual payments and matures in say, 8 years. Simply reinvest the coupon payments in the same security as you receive them. You will be subject to interest rate and reinvestment risk, but again, that is due to the fact that an 8 year security is a medium-term investment. Therefore, you must be able to absorb the additional volatility associated with the additional uncertainty relative to a short-term investment.
But to get back to our long-term investment, the fact that the long-term portion of your portfolio does not require any provision of income implies that any dividends distributed to shareholders will simply be reinvested in the company through the purchase of additional shares. If there is a better opportunity available to reinvest those dividends then by definition the investor should sell their existing shares in favour of the better opportunity. Therefore, there is no benefit to receiving regular dividend payments.
If the company cannot find any attractive projects with which to invest its retained earnings, then it can simply distribute those earnings back to its shareholders through a share repurchase. This reduces the number of shares outstanding, which results in each share representing a greater proportion of ownership in the company. Therefore, earnings per share (EPS) rise and the market price should follow suit. Another way of rationalizing the increase in share price would be to consider the increase in demand for the company’s shares generated by the repurchase, which will drive the market price up.
The repurchase scenario is therefore equivalent to the dividend scenario as shareholders can simply liquidate some shares, which are now worth more due to the share repurchase, placing them in the same situation they would find themselves in had the company distributed its earnings through a dividend distribution.
Exceptional Investors 