The value of an investment is measured in terms of the cash flow that it generates. In the case of equity, shareholders traditionally participate in the company’s cash flow by receiving dividends (DVD). Therefore, dividends act as a proxy for cash flow generation and are an important indicator of profitability. The dividend yield, which is the ratio of dividends to the price paid, is often used as an indicator of how expensive a company is, respectively how much an investor has to pay for a stream of dividends.
Dividends have long been, and continue to be, a key indicator for many investors when making investment decisions. Historically, and to a lesser extent in the present day, the comparison of dividend yield and coupon rate is often taken as a criterion in the Equity/Bond allocation investment decision. As commented by Aswath Damodaran [1] in his blog, in the early years of the equity market in the late 1800s, companies wooed investors who were accustomed to investing in bonds with fixed coupons by offering them predictable dividends as an alternative.
Paying dividends has become a standard practice and companies are reluctant to ever cut dividends. The graph below taken from Damodaran’s blog documents that reluctance by showing that less than 10% of US companies reduce DVD, on average.
Dividend and valuation
The first equity valuation model and investment selection criteria were dividend-based. John Burr Williams, a legendary investor of the 1920s and 1930s, formulated the importance of dividends in his 1938 book, The Theory of Investment Value. His ideas were later reframed by Myron Gordon and Eli Shapiro in the dividend discount model or Gordon growth model published in 1956[2]. In the 1980s, dividends continued to attract the attention of academics and researchers trying to figure out why they are such important information for investors, shareholders and managers. The dividend signaling theory focused on the information conveyed by dividend decisions about the cash flows that shareholders can expect to receive[3]. Dividends are a signal to shareholders and cutting them thus represents bad news for the stock price[4].
Bird in the hand preference
Dividends tend to be paid by mature companies with limited growth opportunities whose cash flow cannot be reinvested profitably, so it is returned to shareholders — definitely a wise management choice. The typical profile of a high DVD yield company is very appealing to many investors: mature; relatively stable cash flow; strong visibility and brand; less risky than the market. These types of companies, so-called ‘cash cows’, do not tend to engage in high-risk investments and are not exposed to innovation and technology driven competition. Instead, they provide peace of mind and are a source of recurrent income for their shareholders. Rather than capital gains placed in an uncertain future (some) investors prefer receiving a flow of dividend payments. For those investors a bird in the hand is worth two in the bush.
Dividend and value
However, despite the attention that investors continue to give to it, and even if pricing models have been developed based on dividends, economic theory is very clear about the relevance of dividends when it comes to the value driver of a company: DVDs play no role. In fact, if we exclude the distorting effect of “frictions” (like taxes or costly, limited access to the market), then dividends, as well as financing decisions in general, have no impact on the value of a company. This is the famous Dividend Irrelevance Theorem, formulated in 1961 by two iconic professors of Finance, Nobel laureates, Modigliani and Miller (MM)[5] stating that, in a world without frictions, the value of a company does not depend on dividend decision. We all know what happens when a company, ETF or a mutual fund pays a DVD: the value of the company, of the fund or the investment vehicle in general goes down exactly by the same amount. You can’t have your cake and eat it too. There is no value creation out of paying dividend.
Dividend yield traps
Many companies do not pay dividends, yet their value is in the billions. Consider all the venture growth stocks, such as biotechnology companies. Not all companies pay dividends, and those that do, do so with varying intensity. Certain sectors tend to pay systematically higher others lower dividends than the market average. It follows that by preferring high-dividend stocks, investors reduce the range of investment opportunities available to them. Even worse they might be caught into a DVD yield trap. Since a reduction or suppression of DVD payments is hardly ever accepted by investors, even companies that are making a loss pay a dividend, as reported in the following table published by Aswath Damodaran on his blog. In his analysis, he has segmented the world equity market according to sectors, differentiating between money-making and money-losing companies and showing the respective aggregated dividend payments of each group.
The sectors of energy, real estate, utilities, materials and financials tend to have the highest dividend yield (last column). It is also interesting to note that companies in all sectors pay a DVD even if they are making a loss (see “% Dividend Payers” column), funded most likely with debt or by selling assets. Paradoxically, keeping the DVD constant even when the company is making a loss might result in an increase in the DVD yield, since the company’s equity price might decline due to deteriorating operating results.
Investment advice
One well-known and widely used valuation model is based on the DVD as a proxy for company cash flow. However, DVD itself is not a driver of company value but rather a signal of how much of that value shareholders can expect to receive in cash (instead of capitalizing price increases). This is clearly relevant for investors who prioritise income and choose high-dividend yield investments. Below are listed some implications investors have to be aware of and concrete investment fixes to address the (high) DVD yield traps.
- For investors with preference for income, the above simple analysis highlights important aspects to be considered when building an high DVD yield strategy. Apart from DVD they need to assess whether and to what extent companies are profitable, not only now, but also in the coming years, ie how sustainable dividend payments in the future are. They need to establish whether DVDs are being paid out of rising debt levels or simply because the company is selling its ‘silver plate’ assets. DVDs can therefore play a role and are a powerful indicator, but in an investment selection model they need to be combined with complementary indicators that address profitability, growth, historical DVD patterns and balance sheet safety. The goal is to build a portfolio by selecting companies with the desired high DVD profile, while avoiding the high DVD yield trap.
- Investors have to be aware that even an articulated DVD yield strategy, with checks and balance, relative and absolute risk control, can incur in prolonged period of underperformance vs the market. In fact, by prioritizing the DVD criteria the title selection ends up being restrictive, by de facto excluding growth stocks (particularly young ones), stocks operating in sectors characterized by high profitability, high valuation, and high investments hence lower payout and DVD. All this implies a substantial deviation from the benchmark and the acceptance of prolonged phase of underperformance.
- Over the last decades companies have increased the proportion of net income destined to share buybacks, which is an indirect way of returning cash flow to shareholders. This has induced many investors to prefer shareholder yield (which combines DVD and buybacks) to dividend yield as selection criteria. Shareholder yield criteria is less restrictive in the stock selection than dividend yield, but it has a lower income generation.
- To generate income a simple solution consists in adopting a wide diversified investment strategy (including also high profitability and growth stocks for example) and generating income by selling part the portfolio. Alternatively, he/she can invest in a fund that regularly distributes the income (dividend and interest) generated by its investments as well as special (tax free) payment out of realized capital gains. Interestingly this practice is not so common among fund management companies.
Carmine Orlacchio, 14.10.2025
[1]Musings on Markets: Data Update 9 for 2025: Dividends and Buybacks – Inertia and Me-tooism!
[2] Gordon, M.J and Eli Shapiro (1956) “Capital Equipment Analysis: The Required Rate of Profit,” Management Science, 3, October 1956, pp. 102-110.
[3] Bhattacharya, Sudipto, 1979, Imperfect information, dividend policy, and the bird in the hand
fallacy, Bell Journal of Economics and Management Science 10, 259-270.
[4] In an article published in Finanz und Wirtschaft on 13th September entitled ‘Nestlé wackelt, aber fällt nicht’, it is argued that the increasing leverage is a consequence of keeping the DVD payment constant, as reducing it for a dividend aristocrat like Nestlé would send out a fatal signal. Following a staggering 35% decline over three years, it is questionable whether the market would be “surprised” by a DVD reduction. It is more likely that the fatal signal has to do with equity holders being favored at the expense of bondholders as long as DVDs are paid.
[5]Miller, Merton H., and Franco Modigliani. “Dividend Policy, Growth, and the Valuation of Shares.” The Journal of Business, vol. 34, no. 4, 1961, pp. 411–33
