Homemade Dividends

Refers to the dividend income generated through the sale of a portion of an individual equity portfolio

Dividend income generated through the sale of a portion of an individual equity portfolio are homemade dividends. 

Homemade Dividends

Such a 'dividend' differs from a traditional one that is distributed to shareholders at the discretion of management. Hence, what makes these dividends 'homemade' is the idea that investors can choose when to sell a portion of their position for income. This is quite different from traditional dividends.

Dividends allow investors to generate cash inflows from their portfolios, which can be used for several purposes, such as paying the bills or reinvesting. 

Example: 

 Let us consider an example of generating dividends in such a manner. 

Example 1: Alphabet Inc (NASDAQ: GOOGL)

Consider a position in GOOGL with the following characteristics:

  • The average cost of $2200 for ten shares
  • Current market price: $2800
  • Unrealized capital gains: $6000 (10*600)

In such a scenario, the investor may choose to sell some part of the position in GOOGL to generate homemade dividends. For example, assume that the individual here wishes to receive a 5% return on his investment in GOOGL. They would need to sell 5% of their position to achieve this. 

Hence, $140 worth of GOOGL stock would be sold to create the same effect as receiving a dividend. Moreover, this strategy can be repeated monthly to generate cash inflows.

Example 2: Federal Realty Trust (NYSE: FRT)

Another application of these dividends is to utilize them with dividend-paying stocks where the investor may demand a larger yield than what is distributed through traditional dividends by management. 

For instance, consider the following position in FRT:

  • 50 shares at an average cost of $110
  • The current market price is $150. Therefore, unrealized capital gains are $2000 (40*50)
  • The dividend yield at current prices is 4.3%

Imagine that you were expecting a dividend yield of 5% from this position. However, this year you find that the dividend yield sits at 4.3%. Therefore, you can trim a small part of your position to address the difference.

This scenario is possible by selling a portion equivalent to receiving 0.7% in dividends. Hence, you can sell $525 (0.07*150*50) worth of stock in FRT. Thus, you create the same effect as receiving a traditional dividend.

What is the Dividend Irrelevance Theory/Homemade Dividend Theory?

The dividend irrelevance theory assumes that traditional dividends serve little purpose as markets perform efficiently. Therefore, any dividends distributed by firms will exactly decline the stock price by the dividend amount.

Therefore, if a stock price is $100 and a dividend payout of $1 is made, then the stock would fall to $99 after the ex-dividend date to reflect the fall in the investable capital of the firm. 

Therefore, investors are not better off holding dividend-paying stocks over non-dividend-paying stocks as stock prices reflect changes in capital.

One US Dollar

Hence, one can argue that these dividends are better for investors eager to generate cash flows as they can control when and how much to receive. Moreover, this also allows investors to own firms in sectors outside of traditional dividend-paying firms, such as telecom, energy, REITs, and other industries.

Thus, following this logic, whether or not a firm pays dividends is unimportant, as investors can choose to sell a portion of their position to create immediate cash flows as they please.

The benefit of a firm not declaring a dividend is that the capital may be reinvested into the business for growth. Thus, in the long term, shareholder value can be maximized. 

However, critics of the theory argue that, as investors create these dividends, they deplete their asset base, which may not be sustainable. Thus, they say that consistent dividend-paying stocks have value due to convenience. Moreover, the firm benefits from positive market sentiment due to this convenience.

Homemade Dividends Versus Traditional Dividends

Which type of investment is better? There are apparent differences between these two dividends. Investors should be aware of the benefits and limitations of each.

Chess Set

Below is a table that summarizes some of the key differences between both types of dividends:

Comparison
Homemade DividendsTraditional Dividends
Requires active trading and monitoring to know when to sellManagement decides when and how much to distribute to shareholders; thus, individuals can invest and forget
Dividends are generated from the partial sale of the position in the firmDividends are a distribution of the profits of the firm
Not subject to management decisionsSubject to the discretion of management
It can be generated from any stock from any industryOnly applicable to dividend-paying stocks, common in only a few industries
No obligation to follow a pattern of generating dividends - based on the individual's goals for the portfolioObligated to accept management decisions on dividend payments
Subject to capital gains taxNot subject to capital gains tax
Investor flexibilityLittle/no investor flexibility

Perhaps the most crucial difference between the dividends is that homemade dividends require ongoing active management by the shareholder, as decisions on when and how much to sell need to be made. 

However, with traditional dividends, the shareholder can purchase the stock and hold onto their position to generate cash flows. The only active management required is for the investor to constantly reevaluate if the firm is performing as expected, which is also the case with homemade dividends.

As investors gradually sell parts of their position to create cash flows, this is not sustainable in the long term as the investor continuously reduces their asset base. However, This is not the case with traditional dividends.

Traditional dividend-paying stocks are also usually limited to a few industries, such as energy, telecom, and utilities, which have paid consistent income, even through recessions.

For example:

Some REITs have a track record of paying out dividends consistently. Even so, investors are limited to these types of businesses in these industries. That is not the case with homemade dividends, as they can be created from growth stocks.

Homemade dividends are, however, subject to higher taxes due to capital gains tax.

To conclude, although key aspects make each investment style attractive, the question of which strategy is better is difficult to address as it depends on the individual's goals and experience. 

That being the case, investors should consider these factors and ask themselves questions that clearly define the purpose of their investments and what they are willing to do. 

For instance, an investor that likes to manage their positions actively may prefer homemade dividends. On the other hand, someone who wishes to manage their portfolio passively may prefer the convenience of traditional dividend-paying stocks.

Advantages & Disadvantages

What are the benefits and limitations of generating current income via these dividends? First, investors should consider some advantages and limitations of such a strategy. 

Up And Down

Below is a table that summarizes the key factors associated with this dividend that investors should consider. Note that some disadvantages may be looked upon positively and vice versa, but, traditionally, these are associated with the following benefits and limitations. 

Advantages and Disadvantages
AdvantagesDisadvantages
Flexibility Need to monitor and manage investments to create cash flows actively
Choose when to receive dividendsBrokerage/transaction costs incurred when selling
Choose how much to receive in dividends - can indefinitely defer taxes by selling positions later.Higher tax liability over traditional dividends as capital gains tax is incurred.
Not limited to dividend-paying stocks to generate cash flows, hence better diversification prospectsGradual decline in asset base as the number of shares falls to realize gains, making it unsustainable long-term.

Note that some factors associated with such a strategy may favor certain investors. For instance, we have listed active monitoring as a disadvantage. However, there are certainly individuals that would prefer actively managing their portfolios over a passive strategy.

Similarly, choosing when to receive dividends and having the flexibility to decide how much to accept in inflows may be a disadvantage for individuals who wish not to spend time and energy thinking about such things. 

Hence, a traditional dividend-paying stock may be a better strategy for these investors.

A key advantage of generating these dividends is that taxes can be deferred indefinitely, as they are incurred when capital gains are realized. Therefore, holding a position longer can push tax liability further in the future. 

Moreover, with these dividends, investors can diversify, investing in different industries, unlike traditional dividend-paying stocks.                                    
Today, brokerage costs associated with selling stocks, especially exchange-traded funds, are negligible. Therefore, this limitation is not as applicable and will be even less so in the future.

Critics argue that this strategy is not sustainable long-term as the investor cannot create dividends forever by continuously reducing his position in the firm. Obviously, at some point, the investor would run out of shares to liquidate.

Thus, such a strategy requires individuals to define how long they wish to create cash flows.

DCF Modeling Course

Everything You Need To Master DCF Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Research and authored by Imran Husain l Linkedin

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: