Dividend Irrelevance Theory Explained & Why It’s Important

Exploring Modigliani Miller Dividend Irrelevance Theory

Today’s topic is dividend irrelevance theory. Also known as the Modigliani Miller dividend irrelevance theory. Or, MM dividend irrelevance theory, for short.

Regular readers know that I am a big fan of investing in stocks that pay dividends. So, why write about the irrelevance of dividend policy?

Because I think it is a good idea to examine the opposing view. To see what can be learned. And, how to use it to make money investing.

And before we are done, I will share with you 3 companies and their stocks. That can make even me a believer. In the irrelevance of dividends.

Furthermore, I will show you how to turn $1,500 into more than $5,000. Using a dividend irrelevance investing strategy. So, let’s do it…

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What Is Modigliani Miller Dividend Irrelevance Theory?

First of all, this dividend theory states that investors do not care how they get their return on investment.

The total investment return is what is important. No matter if it comes from share price appreciation, dividends, or both.

Furthermore, it indicates that a company’s dividend is meaningless. And its dividend policy irrelevant. Because they have no impact on the value of the company or its stock price.

Finally, the dividend irrelevance theory argues that dividends can be a negative for a company. Since the money can and should be used by management in more productive ways.

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

Why Is MM Dividend Irrelevance Theory Important?

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Dividend irrelevance is 1 of 3 dividend theories. And, whether you believe it or not, you have a preference for 1 of these 3 theories.

If you don’t, you should develop a bias. And, be conscious of it. Why?

Because your belief in a particular dividend theory will partially dictate your investment strategy. And, every investor should develop an investment strategy.

Simply put, an investment strategy is a defined approach to investing.  It guides the choices you make as an investor.

Broadly speaking, that’s why dividend theories are important. And specifically, why dividend irrelevance theory is important to understand.

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Before we get rolling, let me give you a few key points from the article.

Dividend Irrelevance Theory: Key Takeaways

1. Management has 4 better options for using company cash than paying dividends.

2. Investors should prefer companies that do not pay dividends. Because, at best, they do not influence the value of the company paying them or its stock. At worst, they can hinder the value of a company.

3. Companies such as Alphabet, Amazon, and Facebook show there are big investment returns to be made. From stocks that do not pay dividends.

4. While critics of dividend irrelevance theory present several valid arguments. Specifically, how dividends add value to companies and their stock price.

Next, let’s dig into the details. And get our hands dirty with dividend theories.

First off I will compare and contrast dividend irrelevance theory with the 2 other popular dividend theories.  Doing so will help you better understand which dividend theory is right for you.

Bird In Hand

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In contrast to dividend irrelevance, bird in hand dividend theory is based on the belief that investors place a high value on receiving dividends. It is sometimes referred to as dividend relevance theory.

Furthermore, bird in hand is based on an old saying. It is “a bird in the hand is worth two in the bush”.

The saying means that it is better to hold onto something you have now, or can count on receiving soon. Versus the risk of losing whatever “it” is. By trying to get something bigger and better down the road.

How does this relate to dividends? Well, it is quite simple…

Payments from high-quality stocks that pay dividends are something you can count on. It is the bird in hand.

In contrast, to the potential for large increases in the share price of a stock. That may or may not come in the future.

Share price increases are the 2 birds in the bush. Or, something potentially better in the future than dividends right now.

That concludes the comparison of dividend relevance and irrelevance theory. But. before we move on, do you prefer investing in stocks that pay dividends?

Then consider the Simply Investing report. Each month Simply Investing sends excellent dividend stock recommendations direct to your inbox. Learn more about Simply Investing here.

Next, one more dividend theory to understand…

Tax Preference

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The third dividend theory is called tax preference theory. It is also known as the tax aversion theory.

While bird in hand theory is the directly opposing view to dividend irrelevance. In my opinion, tax preference theory is more similar to it.

Tax preference theory works off the assumption that an investor’s primary concern is minimizing taxes. And they take them into account when making investment decisions.

As such, investors that follow this theory have a strong preference for share price appreciation. That creates capital gains. Furthermore, they would rather not receive dividends.

Because historically, dividends were taxed at a higher rate than capital gains. And dividends are taxed when received. While capital gains are only taxed if and when an investor chooses to sell a stock.

Tax preference makes good sense. It’s almost always better to be taxed at a lower rate. Also, to defer the payment of taxes for as long as possible.

On the other hand, you can limit this tax issue. By putting stocks that pay dividends in an Individual Retirement Account (IRA) account.

Regardless of your investment choices. Have you been meaning to open an IRA? And start investing for retirement? If yes, I suggest you do so.

But, let’s continue with today’s topic. And do a quick recap of what we have learned so far.

Dividend Irrelevance Is 1 Of 3 Dividend Theories

Thus far we have discussed 3 dividend theories:

  1. Modigliani-Miller dividend irrelevance theory
  2. Bird in hand
  3. Tax preference

Each presents its reasons why the theory will lead to the best possible investment gains. And go along way to explaining how dividends work for a company, or not.

Next, let’s dive deeper into dividend irrelevance theory.

Who Are Modigliani & Miller?

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Dividend irrelevance theory was developed by economists Franco Modigliani and Merton Miller.

According to Wikipedia, Mr. Modigliani was an Italian-American economist.

He received the 1985 Nobel Memorial Prize in Economics. And was a professor at the University of Illinois at Urbana–Champaign, Carnegie Mellon University, and MIT Sloan School of Management.

Also from Wikipedia, Mr. Miller was an American economist.

He spent most of his academic career at the University of Chicago’s Booth School of Business. While sharing the Nobel Memorial Prize in Economic Sciences in 1990.

Dividend Irrelevance Theory Assumptions

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As you can see, dividend irrelevance theory developed in academia. By professors of economics.

Meaning no disrespect, the assumptions of dividend irrelevance theory seem a little impractical to me. Regardless, I will highlight them for reference purposes.

The dividend irrelevance theory assumptions relate to the company and the environment in which it operates. They are:

1. The capital markets are perfect.

2. There are neither flotation nor transaction costs.

3.  There are no taxes.

4. The capital structure does not affect cost. In other words, the cost of capital is constant at any proportion of debt and equity.

5. Both management of companies and investors have equal access to all public and private information.

6. The cost of equity is constant at any dividend payout rate.

7. The dividend policy does not affect capital budgeting.

Next, let’s connect some dots between theory and action. And what some of this “academic-speak” means to real investors like you and me. Trying to decide if dividends are free money so to speak.

Because we operate in the real world. With our hard-earned dollars looking for the right investments. To meet our important financial goals.

Dividend Theories And Dividend Policy Irrelevance

First of all, a dividend theory is a system of ideas to describe a situation. Also, a set of principles upon which a concept is based.

Furthermore, dividend theory provides the basis for a company’s dividend policy. Where dividend policy is the actual corporate behavior that results in dividends paid (or not) to you and me.

Yes, companies that follow the dividend irrelevance theorem have a dividend policy. But, it is very simple. Their dividend policy is such that they choose not to pay a dividend. In other words, dividend policy irrelevance.

Because, by following dividend irrelevance, they feel they have better uses for their cash. Uses that will more dramatically improve the value of the company and its stock price. Versus paying dividends.

To further this point. I want to touch on the other ways a company can use its cash. Let’s do that now.

Then How Should A Company Use Its Cash?

Irrelevance of dividend policy means if a company has cash. And they choose not to pay a dividend. They must do something with this valuable resource.

So, what do they do with their money? Well, companies can spend their money in the following ways:

  1. Reinvest in the business
  2. Acquire other businesses
  3. Payoff debt
  4. Buyback their shares from the stock market

Or, not spend their available cash at all. Just let it accumulate for liquidity purposes.

By following dividend irrelevance theory. And setting a no-payment dividend policy, management is saying 1 or more of the above options are a better use of cash.

Next, let’s see how dividend irrelevance can work in reality. With a small, but real-world investment portfolio. Made up of companies we have all heard of.

Dividend Irrelevance Theory & Investment Portfolio Strategies

Here are several examples of stocks that fit with a dividend irrelevance theory-based investing strategy.

Full disclosure. I do not own any of these stocks. Because I only invest in a stock that pays dividends.

Therefore, I believe in dividend relevance.  It forms the basis of my investment strategy. And dictates the types of investments that I make with my money.

But understanding, there are other investment strategies. That should be considered.

So, for each dividend irrelevance theory example discussed below. I’m going to use stock price performance for the 5 years ending 2020. So, let’s get on with analyzing stocks that have not paid dividends.

Dividend Irrelevance Theory Example 1: Alphabet, Inc.

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Alphabet is better known as the parent company of internet search giant Google. It was created through a restructuring of Google in 2015.

Creating Alphabet Inc. was prompted by a desire to make the core Google internet search business more focused.  While allowing for the grouping of companies that operate in businesses other than internet services.

  • Stock symbol – Nasdaq: GOOGL
  • 12/31/2015 Price per share: $778.01
  • 12/31/2020 price per share: $1,752.64
  • Annual return on investment: 17.63%

Looks like a good return on investment.

Dividend Irrelevance Theory Example 2: Facebook, Inc.

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Facebook is a technology conglomerate. The company offers other products and services beyond its well-known social networking platform. Including Facebook Messenger, Instagram, and WhatsApp.

  • Stock symbol – Nasdaq: FB
  • 12/31/2015 Price per share: $104.66
  • 12/31/2020 price per share: $273.16
  • Annual return on investment: 21.15%

Another money making stock investment plan. For sure!

Dividend Irrelevance Theory Example 3: Amazon, Inc.

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Amazon is much more than the sleepy online book retailer where it got its start in 1994. Now, its business reach includes e-commerce, cloud computing, digital streaming, and artificial intelligence.

  • Stock symbol – Nasdaq: AMZN
  • 12/31/2015 Price per share: $675.89
  • 12/31/2020 price per share: $3,256.93
  • Annual return on investment: 36.96%

And I saved the best stock for last. Oh my. I wish I would have made a plan to invest like this. In Amazon!

Portfolio Strategy Summary: $1,500 to $5,000+

So, let’s pull the returns from these stocks together. Keeping it simple, I will assume an investor bought 1 share of each of these 3 stocks on December 31, 2015. Then, held them until the end of 2020.

Furthermore, remember that none of these companies pay dividends. Following the theory of dividend policy irrelevance.

  • Amount invested on 12/31/15: $1,558
  • Value at the end of 5-years: 5,283
  • Annual return on investment: 27.66%

And, assuming our investor still holds those shares. Not a penny of income tax was due or paid. It sure looks like you can make money investing in these stocks.

On the other hand, some investors that choose an investment portfolio like this sell some of their stock to make their dividends. And create cash for spending. This approach goes by the name of “homemade dividends”.

That’s right, homemade dividends. I like dividends, so it sounds pretty good to me. But, that’s a story for another day.

Finally, regardless of which stocks you choose to buy. Be sure to buy and sell your stocks for free.

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Okay now, just be fair. Let’s address some of the disadvantages of dividend irrelevance theory. Then, I will wrap up.

Criticisms Of Dividend Irrelevance Theory

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1. There are some very good reasons companies pay dividends. Some investors (like me) and exchange-traded funds seek out dividend-paying companies. And will only invest in stocks that pay dividends.

2. With excess cash at their disposal, company management may be prone to “empire building”. Or, just plain old bad decision making on where and how they deploy their cash.

3. To receive cash, dividend irrelevance means investors must sell and reduce their ownership stake.

4. Furthermore, recurring dividends can instill discipline into management. When they know some cash must first be allocated to their dividends. They must make wise choices with the cash that is left over.

5. Not every company will be successful like Alphabet, Facebook, and Amazon.  For every one of these companies, I can find a company where dividend payments were not part of their policies. And failed to invest and innovate wisely. Thus, destroying shareholder value.

It’s time to wrap this up.

Dividend Irrelevance Theory: Summary And Wrap Up

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Let’s sum up the relevance and irrelevance theory of dividends.

First of all, MM dividend irrelevance theory is 1 of 3 prominent dividend theories. It is based on the belief that investors do not care how they receive their investment returns.

And that company’s feel they have more productive uses for their cash. Rather than paying dividends to shareholders.

Furthermore, dividend theories provide the principles on which individual company dividend policies are established. Those policies may or may not put cash dividends in the pockets of dividend investors like you and me.

In the case of companies that believe in dividend policy irrelevance. Their dividend policy is simply that they don’t pay dividends.

Know it or not, as an investor, you have a bias toward one of the dividend theories. And, it partially dictates your investment decisions.

Finally, we looked at examples like Alphabet, Facebook, and Amazon. And saw that investors have been making big money from stocks of companies that believe dividend policy irrelevance.

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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.

I do not own the stocks mentioned in this article.

Your Complete Guide To Dividend Irrelevance Theory