Most ASX investors think of dividends as a wonderful thing, almost mana from heaven. What's not to like?
'Free' money just for owning something. Passive income. Cash flow. All of those things are true. But nothing in life is free. Or perhaps more pertinently, nothing in life comes without a cost.
So let's look at what a dividend truly is. And why it may not be as good as you'd think.
So, as we probably all know, a dividend is a cash payment from a company to its owners, aka shareholders. It's a 'thank you for owning our company's shares' of sorts from management.
Normally, dividends are paid out of a company's after-tax profits. If they are not, you might have a serious problem with your company. Some companies have been known to borrow money to pay dividends, but this is not normally a good sign.
So far, so good?
But here's the problem – opportunity cost. If a company sends a dividend out the door, that money is as good as gone for the company. It can't ever bring it back or invest it in something else. That's why a company's share price will almost always drop when it goes ex-dividend.
The company is less valuable because it literally has less money in its bank account. Every dividend weakens a company. Now some companies do this deliberately. US tobacco companies are famous for paying out as much of their cash as dividends as possible, so they are less of a regulatory target.
But many other US companies choose not to pay a dividend at all, even though they easily could. Think of Facebook Inc (NASDAQ: FB). Or Amazon.com Inc (NASDAQ: AMZN).
These companies are sitting on mountains of cash, which they choose to hold on to. Even Warren Buffett's Berkshire Hathaway Inc (NYSE: BRK.A)(NYSE: BRK.B) hasn't paid a dividend in almost 60 years.
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When is no dividend is a good dividend?
Why? Opportunity cost. If a company's management thinks it can achieve a decent return on capital, why would it give that up? Say a company can return 15% on every dollar it invests. Why would its shareholders prefer the company to waste that opportunity by giving the money away as a dividend when it could be put to work earning 15% for its owners?
There is no franking system in the US, so usually, shareholders don't mind this paradigm. But here in Australia, companies start getting asked 'where's my dividend' as soon as they start turning a profit. If I were a shareholder of a company that could get a 15% return on its dollars, I would be telling the company to reinvest every cent.
Now many of the ASX's most famous dividend payers can't get a knockout return on their investment anymore. Think of the ASX banks like Westpac Banking Corp (ASX: WBC). Or Woolworths Group Ltd (ASX: WOW).
These companies are playing in a saturated market. Almost everyone in the country lives near a Woolies. Or can access a Westpac account if they so chose. Thus it might not be a great idea for Woolworths to open 50 new stores next year instead of paying a dividend. Or Westpac to open another 20 branches. But if I were a Xero Limited (ASX: XRO) shareholder, I would have a very different opinion.
Foolish takeaway
Everything comes at a cost in this world, and dividends, great as they may be, are no different, Something to keep in mind when you're on the hunt for your next ASX share.
