I recently listened to a podcast about investing in dividend stocks.  It is not necessarily clear on how to define a “dividend stock” other than the simple definition that it is a stock that pays a dividend to shareholders.

The only problem with this definition is that there are many companies that pay a dividend to shareholders, but they wouldn’t really be considered dividend stocks because the dividends are so low.  When the current dividend of a stock is lower than the yield on a short-term bond, it is hard to get excited about that stock just because of the dividend payout.  After all, you could just buy an essentially risk-free bond with a higher yield.

This podcast episode sparked some discussions in a forum, which is specifically for people interested in financial independence (FI).  Therefore, you would expect the people in the forum to be somewhat financially savvy, or at least above average.  Unfortunately, a little bit of knowledge can sometimes be harmful.

Someone posted that dividends are the only reason stocks are worth anything.  In other words, stocks really have to pay out dividends or have the potential to pay out dividends in order for the stock to have underlying value.  It was simply an academic point.  He made it clear – at least to me – that this was not investment advice.  He wasn’t saying that you should only invest in stocks that pay dividends.  He was just making the point, “Why would you ever invest in a stock if you knew the stock would never pay out a dividend?”

There is the greater fool theory, meaning that you just hope that someone will buy it from you at a greater price that what you paid.  You don’t care if the stock goes down in price, as long as it happens after you sell it.

It is quite clear that you can make money on a stock that never pays out a dividend, and the original poster on this forum would agree with that.  You can buy a stock, and then later sell it at a higher price.

But if you knew that a stock would never pay out a dividend, why would anyone think this has value in the long run?  What would be the point of owning something that never pays out any of its profits?

The responses to this original post were astounding.  It was one person after another being critical of the original comment. Again, the comment was supposed to be an informative point, and it wasn’t a suggestion to just buy dividend stocks.

The responses kept saying that you can make money on stocks that don’t pay out dividends, even though the original poster made it clear that he agreed with this point.

There were posts saying that dividends are irrelevant to the price of a stock.

There were posts saying that it doesn’t make sense to buy a dividend stock because the price of the stock goes down every time a dividend is paid out.  (This is a lack of understanding of how stocks are valued in accordance with dividend payouts.  The price has to change, all other things equal, otherwise you could buy a stock for $40 per share the day before a dividend payout, and then sell it again for $40 per share the day after the payout is made.  Why wouldn’t everyone do this?)

It was one comment after another of people who were completely missing the point of the post. There were a few people who saw the intelligence of the post and backed him up, but it was a minority to be sure.

There were a few people who pointed out that you buy stock so that you own a tiny share of the company and that you own a tiny share of the assets.  This is correct by itself, but it doesn’t refute the point about dividends.

If you own shares of Microsoft, you could say that you own a tiny piece of the office buildings and the office equipment.  But even this is questionable.  If the company were to declare bankruptcy and all of the assets were liquidated, the senior bondholders would get paid first.  The shareholders are typically last in line.

The reason you would buy Microsoft is not primarily to own the actual assets.  It would be to own a piece of the operations. More specifically, it would be to get a share of the profits from the software and other goods and services that it sells.

Would You Start a Business and Never Pay Yourself?

This is obviously confusing for many people.  Most of the ignorant comments I read were from people who regularly invest heavily in stocks, yet they don’t even understand the purpose of owning a stock outside of “making money”.

Let’s say you start a business.  After the first year, you break even.  Your revenue equals your expenses.

In the second year, your revenue exceeds your expenses by $100,000.  But instead of taking that profit as a salary, you keep it in the bank.  You then decide that you will take that $100,000 and spend it on better equipment and more marketing.  There is nothing wrong with this.  You are trying to grow the business.

The next year, you profit $300,000.  You make the same decision to take this extra money and buy even better equipment and to go even heavier into marketing and hiring more people.

The following year, even though your business is bigger, your profit is still $300,000.  You have to decide whether to put even more money into more equipment, labor, and marketing, or to start paying yourself a salary.

At some point, as the sole business owner, you are probably going to want to start paying yourself a salary, especially when you aren’t getting that much more bang for your buck with more investment capital.

Your other option is to sell the business.  Maybe someone would buy your business for $1 million, counting on the fact that they can turn a profit of $300,000 per year for the foreseeable future.

Paying yourself a salary is similar to getting a dividend from owning shares in a company. The only difference is that the sole business owner can decide himself whether to pay himself a salary. With shareholders, they are dependent on the decision of the company as a whole on whether dividends will be paid.

If you do sell your business without ever taking a salary, there is nothing wrong with this. But you have to assume that the next guy will probably want a salary at some point.  If you just keep rolling all profits back into the business forever, what would be the point of having the business?

That is the same as owning shares in a company.  It doesn’t have to pay a dividend to have value, but there at least has to be a potential of a dividend in the future.  If a company announced that it would never pay out a dividend, there would be no reason to own the company, unless you thought people would foolishly buy the stock knowing this.

Investing Advice

This isn’t investment advice, but I think it is important to know if you are investing.  It is important to understand why something has value and why it is a good idea to invest in something.  It is fine if you just want to try to get capital gains, but you should at least understand why there would be capital gains.

This is a little harder to write right now because there is seemingly a bubble and the “irrational exuberance” that goes with it.  It does become something of the greater fool theory.

But the market usually corrects this over time.  If companies aren’t profitable, they aren’t going to keep going up in value forever.

It’s not to say that a stock is good just because it pays a dividend.  In some cases, the company shouldn’t be paying out a dividend if it is in financial trouble.  If you are a business owner, you might have to cut back your salary (your dividend) during tough times.

If we had a normal functioning free market, I think dividends would be much more common. The tax code and other laws have greatly distorted the whole stock market.  The central bank (the Federal Reserve) has done the same. It is a system that favors capital gains over dividends.

But even distortions can be corrected to a certain degree.  If a company has no dividends, and if it has no prospect of dividends in the foreseeable future, why would the price of the stock go up? The capital gains can’t continue forever without the prospect of dividends.