A popular question among investors, which often comes up after a company has paid a dividend, is “has part of the value of the company declined along with the dividend payment?” Investors may be concerned about this because they view a dividend payment as an outflow of cash from the business, which would weaken the “current assets” portion of the balance sheet. For those who are savvier with financial modelling, does the payment of a dividend mean that it has to be removed from calculations of fair value?
The worry stems from the view that a company is paying out a part of itself whenever it declares and pays a dividend. This action would reduce the net asset value of the firm (all things being equal) and therefore equates to a decline in overall value. Investors who own dividend-paying stocks essentially end up holding a business which either does not grow or is shrinking in value by the year. How accurate are these views?
An operating entity that will continue
Businesses should be viewed as operating entities with recurring revenues and cash flows and, unless there are plans to shut down or wind down the business, it should also be assumed that it is a going concern (i.e. it will continue to operate indefinitely into the future). The ongoing generation of revenue, profits and cash flows means that the value of the firm does not stay static, and any cash flowing out of the company is being replenished again by new business coming in.
Regenerating value for the investor
This flows on to the next point – that value itself is continuously being generated and also “regenerated” when a successful business grows and prospers. As a business is dynamic and forward-looking, investors need to rid themselves of the impression that a company that is paying out a dividend “sheds” part of its value. Through the process of trade and transactional commerce, a company which is doing well is in fact continually creating better value for its shareholders by building its reputation and track record.
Having your cake and eating it too
Investors who own a dividend-paying business are, in fact, having the cake and eating it as well. As an owner of dividend-paying stocks, you enjoy the best of both worlds in the process. On one hand, you enjoy an income from the receipt of dividends from the company, while on the other hand, you also retain ownership of a great business that continues to perform well and churn out cash flows.
The Foolish bottom line
Remember that a business that is growing is adding value to investors even if it pays out a dividend, as corporate strategies and growth initiatives lead to better profit performance and healthier cash inflows. It is therefore not true that businesses lose part of their value after the payment of a dividend but only as long as the business is growing steadily.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.