What are Homemade Dividends?
Homemade dividends are personalized income streams created by an investor by selling a portion of their investment portfolio rather than receiving a dividend to meet cash flow objectives.
The net profit earned by a company is either reinvested in the firm’s operations to generate capital gains or paid out via a dividend to investors.
Sometimes, a company may decide not to pay its regular dividend. Investors relying on this cash flow can replicate this income stream by selling part of their shares in the company. It suggests that investors can be indifferent between dividends and capital gains, as an increase in one, leads to a reduction in the other.
- Homemade dividends are inflows of cash that an investor obtains by partially selling a fraction of shares from his portfolio.
- The premise of homemade dividends stems from the Dividend Irrelevance Theory, which argues that investors do not have to regard a firm’s dividend policy because they can create their own leverage.
- Managers need not worry about the leverage of a company’s fund since investors can create their own leverage condition by making risky and non-risky investments.
Homemade Dividends Explained
Homemade dividends often attract controversy and questions about the traditional dividends’ real value investors can gain through personal leverage.
Based on the above argument, some economic analysts argue that stock price cancels any financial gains since it will decrease at the same rate as the dividend amount on the ex-dividend date.
Such a relationship is inspired by the Homemade Dividend Theory – also known as the Dividend Irrelevance Theory – in which the argument relies on arbitrate prices. The theory holds the belief that dividends are irrelevant to a firm’s stock price.
Implicit to the dividend irrelevance theory is that investors do not need to pay attention to a company’s dividend policy since they can create their own leverage effect. Investors are better positioned to partially sell off their shares and portfolios if they need to generate cash flow.
The counter-argument of the Dividend Irrelevance Theory is that, despite any short-term gain by investors, when they sell a fraction of their shares, they end up with fewer shares and eventually deplete their asset base. It means that a firm’s declaration and payment of dividends help it to raise its stock price.
Homemade Dividends vs. Traditional Dividends
The role of declaring dividend payout is the preserve of a firm’s board of directors. The company determines a record date to decide on eligible shareholders to receive dividends. The last day a seller is entitled to collect rewards, whether sold or not, is denoted by the ex-dividend date.
Payment of normal dividends is usually regular and occurs on a quarterly or monthly basis. Conversely, special dividends typically occur once per year.
Overall, the announcement of a company’s special dividends is made following an exceptional robust performance, or when a company intends to either create a new company or adjust its present financial structure.
The highest dividend yields are associated with companies that historically operate in sectors dealing with basic materials, utility concerns, and oil and gas.
Companies that operate as real estate investment trusts (REITs) or master limited partnerships (MLPs) also pay high dividends. Such companies are well-established and characterized by stable cash flow.
On the contrary, newbie companies and other high-growth firms usually offer low dividends. For example, a company in the technology sector reinvests more of the earnings in research and development (R&D) or expanding its scope of business operations.
Real-World Examples of Homemade Dividends
No dividend scenario
In March 2019, an investor purchased 1,000 Microsoft shares at $250, and the share price rose to $400 by September in the same year; the firm did not declare any dividend.
The investor’s objective was to generate a cash flow of $4,000 by the end of November 2020. He generated a homemade dividend of $4,000 by selling ten shares at $400 each. His remaining shareholdings at Microsoft is now worth $396,000.
It implies that despite the no dividend policy at the firm, the investor still generated a homemade dividend of $4,000.
Declared dividend scenario
Using the above example, assume that Microsoft declared a dividend payment of $4 per share. The company’s stock price will be $396 after the ex-dividend date. It means that his remaining shareholdings will now be $396,000 under the assumptions of zero brokerage, capital gain taxes, or dividend taxes.
Nevertheless, including the above charges will change the scenario. An investor may not be eager to either generate a homemade dividend or collect dividends from the company.
Challenges in Homemade Dividends
- Realistically, it is impossible to sell a portion of shares. Investors will need to trade their shares in multiples of 1 since they are not infinitely divisible. It implies that there will be no more shares to sell after some time.
- When generating income from dividends, taxes are a major setback. Homemade dividends do not lower the tax burden compared to traditional dividends. Instead, they incur capital gains.
- Investors also face the possibility of losing share ownership and eventually losing on future growth. Future returns are lost by partially selling investors’ portfolios.
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