What is a Homemade Dividend?
The homemade dividends refer to the inflow of cash that an investor determines to fulfill his cash flow objectives. He fulfills his cash flow objectives by selling some percentage of shares from his portfolio or receiving the traditional dividends.
Simply put, it is the cash flow created by the investor 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 sell a percentage of his shares/ownership to generate the cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. .
It is different from the traditional dividend announced by the Companies. A firm has a dividend policyDividend PolicyDividend policy is the policy that the company adopts for paying out the dividends to the company's shareholders, which includes the percentage of the amount at which the dividend is to be paid out to the stockholders and how frequent the company pays the dividend amount., announcing the dividend during or after the financial year ends. The basis of the dividend policy is the profit earned by the company. The company may choose not to pay the dividend and reinvest the profit in the operations. If the company does not pay a dividend or an insufficient dividend, the investor may sell a part of the portfolio to generally require the income stream. It is called the homemade dividend theory or the dividend irrelevance theory.
Table of contents
Homemade Dividend Theory (Dividend Irrelevance Theory)
This theory suggests that the investor is indifferent to the dividend policy of the CompanyDividend Policy Of The CompanyA Dividend Policy is a business strategy that deals with the amount of dividend to be paid & the frequency of payment. It has 4 major types, i.e., Regular Dividend, Stable Dividend, Irregular Dividend, & No Dividend Policy. and can sell the shares to generate the required income. This is supported by the argument that when a firm declares a dividend, the company’s stock price decreases by the same amount as the dividend after the ex-dividend dateEx-dividend DateAn ex-dividend date is one of the four important dividend dates, usually set one business day before the record date. It is a deadline; shareholders need to buy the stocks before this date to become eligible for the upcoming dividend payout. It is also called the ex-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. For example, when an investor sells a portion of their 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 if there are no taxes, no brokerage, and shares are infinitely divisible, which is not the scenario in the real world.
Homemade Dividends Explained in Video
Home Dividend Examples
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 dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity..
- The investor had an objective to generate $ 4000 as cash by November end. Hence he sold ten shares of Microsoft at $ 400 and generated a homemade dividend of $ 4000. The investor is left with $ 396000 of shareholding after selling the shares. Thus, Microsoft’s no dividend policy did not prevent the investor from taking home a “homemade dividend.”
Let us see when the Company has declared the dividendDeclared The DividendDividend declared is that portion of profits earned that the company’s board of directors decides to pay off as dividends to the shareholders of such company in return to the investment done by the shareholders through the purchase of the company’s securities..
- Let us assume that Microsoft had declared a dividend of $ 4 per share. Now, after the ex-dividend date, the company’s shares will be for $ 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.
Let us consider another example where a Company has paid the dividend, but it is not sufficient for the investor.
- On 4th September, Allen held 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 stock prices 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 an income of $1000 through dividends.
Challenges/Disadvantages in Homemade Dividend
- Selling fractional sharesFractional SharesFractional share refers to just a part of equity stock which doesn't amount to a single stock unit. Such shares are acquired after stock splits, merger or acquisition, dividend reinvestments, capital gains and dollar-cost averaging. The shareholders cannot sell these stocks in the open market. 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 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 shares. 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 created from the selling of shares.
- Taxes are a major disadvantage while generating income from such dividends. Traditional dividends the company pays generally have lower taxes than the homemade dividend, which incurs capital gains taxes. Thus, these dividends result in more taxes.
- The investor loses his share of ownership and thus loses on future share price growth. While creating a regular income from homemade dividends, investors sell a part of his portfolio, thus losing on future investment returns.
This is the form of generating regular income by selling a part of one’s portfolio. This is done to maintain expected income, which the Companies do not generate due to insufficient or no dividends.
In theory, the investor may be indifferent to the company’s dividend policy and may generate an income equivalent to a dividend-paying company. But once we include brokerage fees and taxes, the future growth potential of the homemade stock 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 and challenges and disadvantages of the same. You may learn more about Accounting from the following articles –