Are Dividends Free Money? (3 reasons they’re not)

Why Dividends From Dividend Stocks Aren’t Free Money

Let’s bust an investing myth today by exploring the question: are dividends free money?

And I’ve got 3 reasons that say they are not.

This is probably a surprise for anyone that has followed me and this website for a while. Since you likely know that I won’t invest in a stock unless it pays a dividend.

Even though I know dividends aren’t free money. Here’s why…

Free money in hand

Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.

Are Dividends Free Money?

In the short term, stock dividends are not free money because when a company pays a dividend, its stock price decreases by a like amount.

During the long term, dividends are not free money since a cash dividend reduces a company’s funds available for business investments.  Where those investments can meet or beat what an individual investor can earn by investing the cash on their own.

Finally, at any time, dividends are not free money because an investor shouldn’t care whether their returns come from dividends paid in cash. Or from share price appreciation.

So, all else being equal, which it rarely is. This means each of these cases leaves the investor in the same position. Whether or not a stock dividend is paid.

Thus, dividends are not free money!

Next, let’s explore each of these points one by one.

But, remember this before you go. Be sure to check out all of our dividend Q&A articles.

Because if there is a question about dividends. We try our best to cover it!

But for now, we will keep moving…

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Dividend Q&A: Why dividends aren’t free money

A Dividend Paid Decreases The Stock Price Per Share

Technically speaking, the share price will drop by the amount of the dividend when it is paid. More accurately the day the stock trades ex-dividend.

Thus, dividends affect stock prices.

I’ve seen this play out first hand. Thinking back to my days of investing in high dividend yield stocks. Which I rarely do anymore.

For example, let’s say you or I invest in a stock with a 10% dividend yield. A dividend that is routinely paid in 4 equal quarterly installments. In other words, a 2.5% dividend yield per quarter.

Furthermore, we will assume the company paying the dividend is very stable. But has little prospects for future growth.

Then you can be almost certain that the day the stock goes ex-dividend for the next quarterly dividend payment. The share price will fall by approximately 2.5%.

The same situation plays out with low dividend yield stocks. But given that stock prices move daily. And go up and down for a variety of reasons.

The reduction in share price on low dividend stocks is more difficult to detect. While the impact on stocks with high dividend yields is usually easier to observe.

But, in either case, the investor is left in the same financial position after the dividend payment. As he or she was in immediately before.

Thus, are dividends free money? No. Not in the short term. This isn’t one of the many ways dividends work for an investor.

But what about the long term? Let’s see…

A Dividend Paid Reduces Management’s Ability To Reinvest In Their Business

First, dividends are paid from a company’s cash flow. Or, its cash reserves.

Second, cash is mainly generated from a company’s earnings.

Third, it takes money. Or, business investment. To make money. And increase earnings.

Thus, when a company doles out its cash in the form of dividend payments. That cash is unavailable to reinvest in the business.

If a company can invest that cash paid out as dividends. And generate a 10% return on investment, for example.

A return that is similar to what investors can earn by investing the dividend into the stock market. Then, the dividend paid is not free money. Why?

Because over the long-run stock prices are closely tied to earnings. And as the company’s earnings grow. As a result of making wise business investments that earn 10%.

Then the company’s stock price should grow right along with earnings. Creating capital gains vs dividends.

And providing the investor a similar return through price appreciation in the company’s shares. Instead of a dividend.

To sum up this point, the investor can receive a cash dividend. Reinvest it into the stocks of their choice and earn 10%.

Or, let the company keep the cash. Invest it. And benefit from that company’s share price rising 10%.

It’s the debate between paying dividends vs investing for organic company growth.

And it leads me to my final point about why dividends are not free money…

Investors Shouldn’t Care Whether They Get Dividends Or Share Appreciation

Whether an investor gets $1 per share by receiving a cash dividend. Or, receives $1 per share because a company’s stock price went up.

They shouldn’t care about if the money is earned from dividends. Or, from a higher share price.

After all, a dollar is a dollar.

Thus, are dividends better than capital gains? Not really, in my opinion.

Better yet, dividends from common stocks are taxed at the personal level when paid. In contrast, capital gains can be deferred until the stock is sold.

Leaving an investor’s money more time to compound. Before having to pay taxes.

So, now that we better understand why dividends aren’t free money. It brings up a very important question…

If Dividends Aren’t Free Money, Are Dividends Worth It?

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Questioning if dividends are worth it

Yes. I still think dividends from dividend-paying stocks are worth it.

Because they provide for making dividend income today. Higher-income from future dividend increases. And share price appreciation over the long-term.

Furthermore, dividends are your money. To do with as you please. And you never have to pay back dividends.

The same can not be said for capital gains. At least not until you sell the stock at a higher price than you paid for it.

So, dividends from dividend stocks remain an excellent way to compound one’s wealth. And it has been documented that stocks that pay dividends often perform better on a total return basis versus stocks that do not.

So, in my opinion, dividends are worth it. Given time and persistence, you can get rich off dividends.

That’s all for today’s dividend Q&A. Allow me to wrap up with a summary…

Are Dividends Free Money?

Here are 3 good reasons why dividend payments are not free money:

  1. A dividend paid decreases the stock price by a like amount
  2. Management can earn a return by retaining and investing the cash allocated to dividends
  3. Investors shouldn’t care how they earn their return on investment

But even after acknowledging these reasons dividends aren’t free money. I still think dividends are worth it!

Since I won’t invest in a stock if it doesn’t pay a regular, recurring, and rising dividend income stream to investors.

So, you should know my answer to this final question…

Are Dividends Good?

Yes. Dividends are good.

First, because of the steady dividend income earned by investors.

Second, due to the potential for dividend increases and share price appreciation moving forward into the future.

So, if you want to know more about making money from dividends.

Then check out our robust article set about dividend investing and dividend stocks before you go.

My Favorite Dividend Investing Resources

Here are some of my favorite tools and resources for building out my dividend stock portfolio. I bet they can make you a better dividend investor too…

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Conclusion is written on a whiteboard

Author Bio: Tom Scott founded the consulting and coaching firm Dividends Diversify, LLC. He leverages his expertise and decades of experience in goal setting, relocation assistance, and investing for long-term wealth to help clients reach their full potential.

Why Dividends Aren’t Free Money Explained