What are Homemade Dividends?
Homemade dividends refer to a form of investment income that investors generate from the sale of a percentage of their equity portfolio. The investor fulfills his cash flow objectives by selling a portion of shares in his portfolio instead of waiting for the traditional dividends. Usually, if a shareholder needs some cash inflow, but it is not yet time for a dividend payout, he can sell part of the shares in his portfolio to generate the required cash inflow.
The ability of investors to generate their own dividends instead of awaiting the regular dividend payouts has sparked discussions on the real value of traditional dividends. This argument is supported by the dividend irrelevance theory, which states that investors do not need to stick to a company’s dividend payment policy since they can generate cash inflows by selling a portion of their equity portfolios.
- Homemade dividends refer to a form of investment income that is earned by selling a portion of the equity portfolio.
- Investors can sell a portion of their stocks to generate the required cash inflow, where the traditional dividend is insufficient or not forthcoming.
- Proponents of homemade dividends have questioned the real value of traditional dividends since investors can sell a portion of their stocks to meet their immediate cash flow needs.
Understanding Homemade Dividends
The homemade dividends concept is different from the dividend policy that is applied by companies. Generally, when a company reports a profit at the end of the year, it returns the value to its shareholders by distributing a portion of the reported profits as dividends. The dividend payout seeks to maximize the shareholder’s stream of income. However, the company may decide not to distribute dividends in a particular year and reinvest the funds into the company’s operations or finance a new venture.
Still, if a company distributes the profits as dividends, the dividend payout may not be sufficient to meet the cash flow needs of shareholders. If an investor does not need the cash flow generated immediately, he can choose to reinvest the company’s income by buying additional stocks. Where the dividend is insufficient to meet the cash flow needs of shareholders, a shareholder can generate immediate cash inflows by selling a portion of their stocks. This concept is known as the dividend irrelevance theory.
Dividend Irrelevance Theory Explained
The dividend irrelevance theory is sometimes known as the homemade dividend theory. It suggests that investors are indifferent to the dividend distribution policy of a company, and they can sell a portion of their equity portfolio to generate immediate cash inflow.
This position is supported by the argument that a company’s stock price decreases by an equal amount as the dividend after the ex-dividend date when a dividend is declared. This argument states that there is no difference if an investor decides to sell a portion of his equity before the company’s board of directors declares a dividend or after the ex-dividend date.
The dividend irrelevance theory claims that paying dividends can affect a company’s competitiveness in the future. The money paid out as dividends would be better reinvested into the company to increase its profitability. Critics of the dividend irrelevance theory argue that, when an investor sells a portion of his/her equity portfolio, they will end up with a reduced number of shares and a depleted asset base. In supporting the dividend distribution policy, the critics argue that dividends help increase a company’s stock price.
Homemade Dividends vs. Traditional Dividends
Traditional dividends are the regular dividends that are declared by the board of directors of a company. After the dividends have been declared, the company determines the record date when the eligible shareholders to receive the dividend payout are identified. The normal dividend is distributed periodically, either monthly, quarterly, bi-annually, or annually.
In periods when the company reports unusually high earnings, the board of directors may declare a one-time special dividend in addition to the regular dividend. The regular and special dividends do not reduce the shareholder’s stocks, and they are issued for each share held.
In contrast, the amount of homemade dividends is determined by the investor rather than the company’s board of directors, as is the case with traditional dividends. The investor decides the portion of stocks to sell to meet their cash inflow needs. Unlike traditional dividends, homemade dividends reduce the number of shares held by the investor and subsequently deplete its asset base.
In the long term, investors who receive traditional dividends will have a higher number of stocks in their portfolio compared to investors who redeemed a portion of their stocks for homemade dividends. It means that investors who receive homemade dividends lose on future growth in stock price.
Limitations of Homemade Dividends
One of the challenges of homemade dividends is investors may incur higher transaction costs compared to traditional dividends. When selling a portion of shares in their portfolio, investors will incur brokerage costs, lowering the income generated from the sale.
In some cases, the brokerage costs may exceed the total homemade dividend income, diminishing its intended purpose. Traditional dividends have low transaction costs since the company disburses funds directly to the investor’s account.
Another limitation of homemade dividends is that they attract higher taxes compared to traditional dividends. When selling shares in the public market, investors will be required to pay capital gains tax on the sale proceeds. In contrast, traditional dividends are paid directly to shareholders and are not subjected to capital gains tax.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: