Homemade dividends is a concept that in liquid markets an investor can alter a company's dividend policy to match his own cash flow objectives.
If an investor receives a dividend when he does not want any cash inflow, he can simply reinvest the amount in the company's stock. On the other hand, if he needs some cash inflow but the company is not paying anything, he can sell off some of the stock to generate the needed cash inflow.
The homemade dividends theory is used to justify the irrelevance of dividend policy for investors. It suggests that investors are indifferent between dividends and capital gains because total return on a stock is made up of both dividends and capital gain. An increase in one is bound to reduce the other.
On 1 January 2012, Alex bought 100 shares of Google (NYSE: GOOG) stock for $642.5 per share. His investment amounted to $64,250. By 30 November 2012, Google stock price had climbed to $699 but it had paid no dividends. Alex needed cash so he encashed the capital gain of $56.5 per share as homemade dividends by selling 8 shares (capital gain per share of $56.5 multiplied by the number of shares (100) divided by current share price ($699)).
Alex's holding as at 1 January 2012 amounted to $64,250 and his total shareholding as at 30 November 2012 was worth $64,308 (699*92). He converted $5,650 of capital gain into dividends and Google's no dividend policy had almost no effect on him.
Written by Obaidullah Jan, ACA, CFA