When looking for companies to invest in, as a dividend investor, the initial screen is to weed out any companies that do not pay a dividend. This has weeded out powerhouses such as Apple, Inc., which have experienced a considerable amount of capital appreciation over the years, but which are otherwise overlooked because they horde cash. (Up until recently of course, when Apple officially announced they would start paying a quarterly dividend). However, in the world of finance, if an investor wishes to invest in a company that does not pay a dividend outright, they can use homemade dividends to replicate the income stream of a dividend paying firm. A good definition of homemade dividends can be found at Investopedia:
A form of investment income that comes from the sale of a portion of shares held by a shareholder. This differs from dividends that shareholders receive from a company according to the number of shares the shareholder has.
So, how does this strategy work? The theory is, that if you require an income stream, you can sell off shares of the company that you own, replicating the dividend. This is a relatively simply operation, and easy to illustrate in Excel. For example’s sake, say we have the following information:
- The current stock price is $10.00
- We require a starting dividend payout of $0.15/year (yielding 1.5%, which not uncommon)
- We would like to see annualized dividend growth of 5%; this is in line with many dividend aristocrats
The above illustrates a common example: when doing research we usually know what the current price of a company is, and what our expectations of the dividend — and growth in that dividend — are. A homemade dividend would sell a partial amount of the share to replicate the dividend payout. So at the end of year one, if you require a dividend of $0.15/share, you would sell off 0.015 shares of the company, leaving you with 0.985 shares at the end of the year. With your required dividend growth of 5%, in year 2 you would require a dividend of $0.1575/share, and you would sell off an appropriate partial share to generate that cash flow. The following table summarizes 20 years of homemade dividends, using our example above:
|Year||Starting Shares||Share Price||Value of Holdings||Dividend||Effective Dividend Yield||Shares to Sell||Closing # of Shares|
Observing the above, we can see that as time goes on, the dollar amount of your investment is decreasing over time, and this is because we are assuming that there is no appreciation of the share price over time. Realistically we would want to see some share price growth. With that in mind, we can add in one more column which adjusts for share price growth. I will save you the derivation of the formula, but g was calculated from the following:
Where the i subscript are growth, dividend, and price, for year i. With this additional information, our example then becomes:
|Year||Starting Shares||Share Price||Value of Holdings||Dividend||Effective Dividend Yield||Shares to Sell||Closing # of Shares||Required Price Growth (g)|
The logic in the above is that we must maintain a share price which allows us to keep paying a dividend forever. Obviously, over time if we are selling partial shares, this number of shares that we have available to create our homemade dividend, thus we the price of the share must appreciate to compensate for the lower number of shares. Observing the table, growth rates of 1.52% in Year 1 up to 2.65% in Year 20 are actually pretty realistic; over a 20 year time period, the share price has actually gone up less than 50%, and has a CAGR of only 1.94%! So this annual required growth of the share price is not out of line with what we would expect to see for any well managed firm; in fact, we would expect to see the same for a regular dividend company anyways.
So, what are the challenges with using homemade dividends?
The obvious first challenge is that selling partial shares is not realistic; most brokerage houses will not allow you to buy or sell partial shares. In our example above, in year 1 we would have to sell 0.015 shares, which likely isn’t possible for the majority of retail investors.
The second challenge is related to cost. In a perfect world, there would be no transaction costs for a homemade dividend. Alas, we do not live in a perfect world. So the activities involved in selling the shares to create the homemade dividend would likely incur brokerage fees which far exceed the dividend itself. This compares to a traditional dividend where the firm pays us the dividend, so the transaction is virtually free for us: all we have to do is sit back, and wait for the dividend to arrive.
Third, we haven’t taken taxes into account. Dividends are taxed at a more favourable rate than capital gains, but by selling partial shares, we are triggering a capital gains tax. This results in more taxes being taken out over time.
Finally, the required growth price of the company, while realistic in terms of value (less than 2% CAGR in share price gives us an annualized dividend growth rate of 5%), having a constantly increasing g may not be realistic.
In theory, homemade dividends allow an investor to replicate the income stream from a conventional dividend paying firm. However, when you take into account brokerage fees, taxes, and the difficulty in selling partial shares, it becomes evident that for the average retail investor, homemade dividends are not as effective in practice as in theory.