What is Homemade Dividend?
The homemade dividend is the cash flow created by the investor himself by selling a portion of his portfolio. Investors may have cash flow objectives. To meet these objectives, the investor can either get the traditional dividend from the Company or the investor may sell a percentage of his shares/ownership to generate the cash flow.
This is different from the traditional dividend announced by the Companies. A firm has a dividend policy and they announce the dividend during or after the financial year ends based on the profit earned by the Company. A Company may choose to not pay the dividend and reinvest the profit in the operations of the Company. If the Company does not pay a dividend or pays the insufficient dividend the investor may sell a part of the portfolio to generally require the stream of income. This is called homemade dividend theory or the dividend irrelevance theory.
Homemade Dividend Theory (Dividend Irrelevance Theory)
This theory suggests that the investor is indifferent to the dividend policy of the Company and can sell the shares to generate the required income. This is supported by the argument that when a firm declares a dividend the stock price of the Company decreases by the same amount as the dividend after the ex-dividend date. Thus, it does not make a difference if the investor sells the stock before the dividend is announced or after the ex-dividend date as it neutralizes any financial gains.
However, this may not be true in the real world. When an investor sells a portion of its portfolio or shares in a Company, he is left with fewer shares for a short-term monetary gain. Further, the dividend irrelevance theory only holds true if there are no taxes, no brokerage and shares are infinitely divisible which is not the scenario in the real world.
Home Dividend Example #1
Let us consider the following examples:
- An investor bought 1000 shares of Microsoft at $ 250 in March 2018. By September 2018 the share price rose to $ 400 and the Company did not announce any dividend.
- The investor had an objective to generate $ 4000 as cash by November end, hence he sold 10 shares of Microsoft at $ 400 and generated a homemade dividend of $ 4000. The investor is left with $ 396000 of shareholding after he sold the shares. Thus, the no dividend policy of Microsoft did not affect the investor from taking home a “homemade dividend”.
Let us see when the Company has declared the dividend.
- Let us assume that Microsoft had declared a dividend of $ 4 per share. Now, after the ex-dividend date, the shares of the Company will be at a price at $ 396 i.e. after deducting the dividend from the price of the shares.
- Thus, the investor now will have $ 4000 as dividend and 1000 shares @ $ 396 making his shareholding at $ 396000.
- This is assumed that there are no capital gains taxes, dividend taxes or brokerage. However, this scenario will change after we include these charges an investor might not be indifferent to receiving the dividend or generating a homemade dividend.
Home Dividend Example #2
Let us consider another example where a Company has paid the dividend but it is not sufficient for the investor.
- On 4th September, Allen holds 500 shares @ $ 31.4 of a Financial services Company which paid a dividend of $ 1.4 per share. Allen was hoping to generate an income of $ 1000 from the shares of the Company i.e. he was expecting a dividend of $ 2 per share. The ex-dividend date is 12th September.
- Allen is expecting to generate the required amount by using this theory. He waits till the ex-dividend date to get $ 1.4 dividend per share. After the ex-dividend date, the prices of the stock will trade @ $ 30 per share.
- Thus, after receiving the dividend Allen will sell 10 shares of the Company @ $ 30 generating $ 300 in the homemade dividend.
- Allen has thus generated income of $1000 through traditional dividend and homemade dividend.
Challenges/Disadvantages in Homemade Dividend
- Selling fractional shares is not realistic. Since the shares are not infinitely divisible, the investor will have to sell shares in a multiple of 1, which means the investor will have no shares to sell after some years. Selling 0.5 shares or any fraction as such is not possible in the real world.
- There is brokerage involved in the selling of shares. In a perfect world we may think we do not incur any transaction costs but in the real world, transaction costs could lower the returns or income generated by selling of shares. As compared to traditional dividends where there is no brokerage and investors get the money in their bank account, It incurs brokerage fees which may exceed the total homemade dividend such created from the selling of shares.
- Taxes are a major disadvantage while generating income from the homemade dividend. Traditional dividends which are paid by the Company generally have lower taxes than the homemade dividend which incurs capital gains taxes. Thus, homemade dividends result in more taxes.
- Investor loses his share of ownership and thus losing on future growth in the share price. While creating a regular income from homemade dividend investor sells a part of his portfolio thus losing on the future returns on investments.
This is the form of generating regular income by selling a part of one’s portfolio. This is done to maintain expected income which is not generated by the Companies due to insufficient or no dividend at all.
In theory, the investor may be indifferent from the dividend policy of the Company and may generate an income equivalent of a dividend paying Company. But once we include brokerage fees, taxes, the future growth potential of the stock homemade dividends may not be as effective as traditional dividends.
This has been a guide to what are Homemade Dividends? Here we discuss homemade dividends examples along with challenges and disadvantages of the same. You may learn more about Accounting from the following articles –