3/3: When high dividends penalize the shareholder
A dividend is not a source of wealth creation. This is what the second part of our series sought to prove. Today, we will see that dividends can even become a "false friend" for the shareholder.
Cash distribution as an admission of weakness
A company raises capital from its shareholders to finance projects with the objective of generating a return on that capital. However, a high payout policy can reveal a lack of projects relative to the capital entrusted to the company.
Imagine Company A, which boasts a 5% annual return and pays no dividend (in order to reinvest). All else being equal, the share price will follow the same trajectory and grow by 5% each year. After 10 years, a share initially worth $100 will be worth $162.89.
Now take the case of Company B with the same return but distributing its earnings every year ($5 for a $100 share). Being cautious, the shareholder places these dividends in a savings account at 1%. After 10 years, they will hold a share still worth $100 and will have received $50 in dividends plus $2.31 in cumulative interest. In all, they will have $152.31, significantly less than the shareholder of Company A.
Receiving dividends may seem like good news at first glance. But it raises a fundamental question: is the money better invested inside or outside the company?
This is the essential dilemma facing a shareholder. From a wealth maximization perspective, is it better to leave one's capital within the company or to recover it gradually in the form of dividends?
Seeking to recoup part of an investment through dividends assumes the ability to reinvest it elsewhere under better conditions (or less unfavorable ones if the company's future is in doubt). Otherwise, a dividend-focused strategy will not be the optimal choice for wealth management.
A penalizing tax classification
Taxation can also be unfavorable to dividends, leading to a paradoxical situation. Dividends are treated as taxable income rather than a return of invested capital. This distinction is far from neutral.
Suppose you invest $100 for one share in a company with several projects (a sort of SPAC). Some time later, some of these projects are put on hold and the company decides to return part of the cash entrusted to it as a dividend ($30 per share).
Theoretically, the operation is neutral. Except for one detail: the 31.4% flat tax (PFU) will erode the dividend received. You will receive $20.58 in net dividends instead of $30, and your residual wealth will be only $90.58 ($70 in shares and $20.58 in cash).
Admittedly, you could theoretically deduct your capital loss if you sell your share for $70 (achieving tax neutrality). However, this deduction is only possible if you have capital gains elsewhere to offset it.
Far from enriching you, the dividend will have diminished your wealth, whereas a simple prior sale of your share for $100 would have been accounting-neutral (as no capital gain would have been realized).
The dividend, therefore, does not always make the shareholder's fortune...
