Here's an illustration:
Imagine that you have two IRAs in which neither capital gains nor dividends are taxed. In each account you have stock such that you own one percent of two one-million-dollar companies, Divcorp and Capgains – let’s say a thousand shares of each. Each has an unlimited menu of investment projects it can undertake that earn a return of six percent. Capgains pays no dividend, but Divcorp pays a dividend of five percent every year on the last day of the year. After two years you want $1,000 to buy widgets and clothe your kiddos, so you order $500 to be withdrawn from each account. After three years you’re curious how well your two account balances are doing.
Your 1000 shares of Capgains are worth $10,000, so the initial share price is $10. After one year it’s $10.60, and after two years is $11,236, with the security price having appreciated to $11.24/share. At that time, you need $1,000, so you go ahead and sell 44.5 shares. Your remaining 955.5 shares are worth $10,736. After one more year, at the end of year three, you have 955.5 shares of Capgains stock worth $11.91 each; the value of the account is $11,380.01.
What about your Divcorp stock? Your Uncle Rich told you it was a really solid company, as evidenced by its consistent dividend history, so you bought the same amount of it as Capgains corp. On the second-to-last day of year one, it was worth $10,600; then, the company paid out a dividend of $.53/share, which netted you $530. Your shares fell in value to $10,070, but you bought $530 worth of Divcorp stock at $10.07/share – an additional 52.63 shares. You have 1052.63 shares worth $10.07 – that’s $10,600. As you can see, in years that you reinvest dividends, the payment of the dividend does nothing at all.
Divcorp is just as prosperous as Capgains in year two, and your shares have appreciated from $10.07 to $10.67. On the second-to-last day of year two, your holdings are worth $11,236 – your shares, 1052.632, times $10.67. On the last day of the year, the board pays a 5% dividend; that’s 53.4 cents per share this year. Your shares are now worth $10.14, and you have $561.80 in cash. You reinvest $61.80 and buy 6.094 shares of Divcorp – so now you’ve got 1058.726 shares. At the end of year three, before the dividend is paid, the shares have appreciated to $10.75. How much are your 1058.726 shares worth? $11,380.
There is nothing magical about dividends. When a company pays you a dividend it is slaughtering chickens just as surely as you are slaughtering chickens when you sell a share. Even in a world without taxes, costly signaling, and so forth, the difference is that you can at least control the timing when you don't insist on a dividends strategy.