When invest in stock market, why are people so hard up over dividends?

[specuvestor]

I was thinking, dividends dont matter. The idea of receiving dividends every year sounds nice, but if you think carefully, its just left pocket right pocket. When you receive dividends, the share price will drop together with the dividend.

In fact, having no dividend is better because you are in control of when you receive your dividend.

Shouldnt other valuation ratios like PE, NAV, debt, gearing,growth be more important?

So really, why are people so hard up over dividends when they invest?

Many people have learnt the hard way that in investing, it is more important to avoid losers than to pick winners. As a result it makes sense to use indicators that suggest that a particular stock is unlikely to be a loser. Dividends have emerged as one of these indicators.

Franco Modigliani and Merton Miller developed a theorem that showed that all things being equal, there was no difference in market value between a firm that paid dividends and one that did not. In layman terms this is the "left pocket right pocket" idea where you can create your own dividend by selling a few shares.

However the theorem makes some important assumptions:

No taxes
No bankruptcy cost
No agency cost
No information asymmetry
Efficient market

All of the above assumptions are untrue to varying degrees in the real world, with the result that there IS a difference in market value between 2 companies that differ only in their dividend rate. Unsurprisingly the dividend payer is usually valued higher. A bird in the hand is worth two in the bush, as it were. In layman terms: "show me the money".

In theory, lousy businesses that generate a low return on their activities should pay out everything. Good businesses should reinvest everything.

In practice, lousy businesses cannot generate free cash and not only consume all the cash they produce but must also borrow more money to expand. Good businesses generate cash in excess of reinvestment opportunities and can afford to pay a dividend.

One might then ask - why do some low-return businesses still pay a dividend when their balance sheet suggests they should pay down debt? Because if they don't, their market value would fall and it would hamper their ability to raise money via a placement.

One might also ask - why don't the high-return businesses use their cash to expand more aggressively? Because if they did, their returns would fall, and they wouldn't be good businesses any more.

Look at Berkshire Hathaway - it has compounded at 20% for decades. But the companies within Berkshire did not compound at that rate. Instead they all generated cash that was sent to Warren Buffett to reinvest. He used that money to buy other businesses which sent him more cash, and so on.

Anyone hoping to emulate Buffett should study what he does - and what he does is buy dividend-paying companies.

As usual, YMMV.

Merry Christmas!

Great post by d.o.g as usual... my humble 2 cents add:

1) Dividend is cash flow. Real money. Earnings is funny money

2) What is the diff between a company that pays you $1 cash so you can subscribe for $2 rights, vs one that just do a $1 rights (excluding the ulterior motive of major shareholder increasing their stake)? You know the former actually got real cashflow to pay $1.

3) Dividends gives you cash to do something while retaining the asset. To get cash from capital gains you need to sell assets. They are not the same thing though theory tells you otherwise. Recycling of capital ie payback period is very important.

Seasoned investors know the importance of cashflows, which is what fundy investing is all about. When cashflows within the company does not translate to cashflows for outside equity or bond holders (continually refinancing the principal or increasing quantum)... it is a red flag.

As d.o.g insinuated rightly: Finance 101 and practice is not the same thing.

The obvious conundrum is that Berkshire prefers dividend but it hardly pays out dividend. The question is actually: Do you believe Berkshire has the cashflow or just another Madoff? For most other companies, our faith is not so secure.