Dividends are not a bonus

Published in The Sunday Times on 26th October 2025.

Income investing has deep historical roots, dating back to the 17th century when the Dutch East India Company paid regular dividends to shareholders. Over time, dividend-paying stocks became a cornerstone of wealth-building strategies, especially in the 19th and 20th centuries as railroads, utilities, and industrial firms offered reliable payouts.  

Dividends feel real

Unlike paper gains, they show up in your account. Dividend-paying companies are often seen as stable, mature, and less volatile. And regular payouts force management to be prudent with capital. And there’s a signalling aspect - initiating or increasing dividends is often interpreted as a sign that management believes earnings are sustainable.

Conservative investors, particularly in the charity and non-profit sectors, embraced income-focused portfolios for their stability and cash flow. Reinvested dividends have historically driven a large portion of total equity returns – over 40% according to UBS global investment returns yearbook. And when you look at a chart of compound returns with and without income reinvested, the return difference is stark. This has boosted the allure of dividends.

The allure of income in a rate cutting environment

Now with central banks signalling rate cuts, investors are looking for stable income alternatives to cash and bonds. This is boosting interest in equity income funds. What’s not to like?

There is something captivating about dividend income that it often seems to lead investors to assume that it’s some sort of bonus. Dividends aren’t a bonus — they’re a withdrawal from the company’s value. When a company pays a dividend, it’s transferring part of its assets to shareholders, which reduces its book value and often its share price. So while income investors may value the cash flow, it’s important to remember that dividends come from somewhere — they reduce the capital left in the business to grow. 

But importantly – as far as total return goes, in many cases you are better off not receiving a dividend at all and allowing companies to retain their earnings.

Why might you bet better off not receiving a dividend?

British fund manager, Terry Smith, provides a good framework for thinking about this. Dividends are taxable in the hands of most shareholders. The exact amount of tax payable will depend upon where the shareholder is resident and which tax band they are in. If you are in Ireland and a higher-rate taxpayer, dividend income will be taxed at 52 per cent, so you will only be left with 48 cents out of every Euro of dividend to reinvest. 

The second handicap of distributed income is that you reinvest at the market price for the shares. If we take the example of a company that’s trading on a price to book of 3.8x (the current MSCI World price to book ratio), this means that you will get to own just 12.6 cents (48 ÷ 3.8) of the company’s capital for every €1 paid out in dividends. 

Retained earnings avoid this tax drag and dilution. If the company retains the €1 instead, it adds €1 of book value directly to the business. That €1 retained boosts shareholder equity by 7.9× more than the €0.126 gained through taxed reinvestment.

Yes, the €1 retained in the company would be subject to tax when the shareholder sells eventually. But it does highlight how high taxes and a high price-to-book ratio can severely reduce the efficiency of reinvested dividends — making retained earnings a far more powerful tool for compounding shareholder value. 

No one can tell in advance whether paying a dividend is a company’s best use of cash. So there is the assumption that the company continues to earn a good return on capital. Not an outlandish assumption.

Compounded returns

Warren Buffett’s Berkshire Hathaway has not paid a single cent in dividends in its 60 year history. In an alternate world in which Berkshire paid out 50% of earnings in the form of dividends (which are reinvested in the stock) how would the return to shareholders compare? Terry Smith looked at this from 1977-2017. An income focused investor ends up with a portfolio less than one sixth the size of the retained earnings investor. This is quite extraordinary.  

The compounding of income is a feature of equities which few asset classes possess. It is not a feature of bonds or property. Investors receive interest or rent from these investments, but they are not reinvested for you.

What if you need an income?

Income is a tool, not the goal. If you need an income from your equities, sell some stock to fund it. Redeeming units is simply a controlled withdrawal of your own capital, on your terms. The right approach to investing is to invest for the maximum total return you can achieve in the most diversified manner subject to your risk budget.

By focusing on total return, you prioritise wealth creation first, and income second. That’s a more sustainable path to better outcomes.  
 

Source: Data is sourced from Bloomberg as at market close 31st December, returns are based on total indices in local currency terms, unless otherwise stated.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on X at @gconno1.