Many investors seek out stocks that pay dividends in order to provide income from their portfolios. However, it's important to understand the accounting impact that dividend payments have on a company's financials. Even though dividends put money in shareholders' pockets, it comes at the price of actually decreasing stockholder equity in the company following the dividend payment.
The common-sense reason why dividends reduce stockholder equity
Looking at the accounting details of dividends can be tough for many investors to understand. But it's useful to look at the question of what impact a dividend payment has on the value of stockholder equity from a more intuitive, common-sense viewpoint.
To do so, think about what happens when a company pays a dividend. The company takes cash that it has available and pays it out to shareholders. From the company's perspective, the dividend reduces the amount of cash that the company has, without any offsetting increase in value elsewhere. Therefore, the intrinsic value of the company falls because of the dividend.
From the investor's perspective, however, there should be no change in the total value of their holdings. The value of their company stock decreases by the amount of the dividend, but they also hold the cash received in the dividend. Even though the company sees a reduction in value in isolation, the value of the dividend compensates for that reduction.
Accounting and dividends
Looking at the formal accounting for dividends clarifies the way in which stockholder equity falls. When a dividend is declared, the company reduces the amount of Retained Earnings by the value of the dividend, creating an offsetting liability for Dividends Payable. The reduced Retained Earnings has a direct downward impact on stockholder equity.
Later, the company pays the dividend. At that point, the amount of cash falls, satisfying the liability for Dividends Payable. The payment has no impact on stockholder equity, leaving the previous downward movement in place.
The key point for investors is that the decline in stockholder equity doesn't mean that the dividend takes value away from them. Rather, it simply places capital that was previously locked within the business and makes it available to shareholders for their use. For many investors, that's exactly the result they want.
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