Dividend theory

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Dividends and share price growth are the two ways in which wealth can be provided to
shareholders. There is an interaction between dividends and share price growth: if all
earnings are paid out as dividends, none can be reinvested to create growth, so all
profitable companies have to decide on what fraction of earnings they should pay out to
investors as dividends and what fraction of earnings should be retained.

This article will deal first with some theories on dividend payments. It will then look at
practical matters that have to be taken into account and will also discuss particular
dividend policies.

Theories

The relevant theories are:

The dividend valuation model

The Gordon growth model
Modigliani and Miller’s dividend irrelevancy theory.

The dividend valuation model

This states that the value of a company’s shares is sustained by the expectation of future
dividends. Shareholders acquire shares by paying the current share price and they would
not pay that amount if they did not think that the present value of future inflows (ie
dividends) matched the current share price. The formula for the dividend valuation model
provided in the formula sheet is:

P0 = D0 (1+ g)/(re – g)

Where:

P0 = the ex-div share price at time 0 (ie the current ex div share price)
D0 = the time 0 dividend (ie the dividend that has either just been paid or which is about
to be paid)
re = the rate of return of equity (ie the cost of equity)
g = the future annual dividend growth rate.

Note the following carefully:

P0 is the ex div market value. The formula is based on an investment costing P0 and
which produces the first inflow after one year and then every year thereafter. If the first
income arises after one year the share value must be ex-div as a cum-div share would
pay a dividend very soon indeed.

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The top line of the formula represents the dividend that will be paid at Time 1 and which
will then grow at a rate g. The use of the expression D0(1 + g) has an implicit assumption
that the growth rate, g, will also apply between the current dividend and the Time 1
dividend – but it need not apply if a change in dividend policy is planned.

The formula can be usefully rewritten as.

P0 = D1 /(re – g)

Where D1 is the Time 1 dividend.

It cannot be emphasised enough that g is the future growth rate from Time 1 onwards. Of
course, the growth rate isn’t guaranteed and the future growth rate is always an estimate.
In the absence of other information, the future growth rate is assumed to be equal to the
historic growth rate, but a change in dividend policy will undermine that assumption.

The Gordon growth model

This model examines the cause of dividend growth. Assuming that a company makes
neither a dramatic trading breakthrough (which would unexpectedly boost growth) nor
suffers from a dreadful error or misfortune (which would unexpectedly harm growth), then
growth arises from doing more of the same, such as expanding from four factories to five
by investing in more non-current assets. Apart from raising more outside capital,
expansion can only happen if some earnings are retained. If all earnings were distributed
as dividend the company has no additional capital to invest, can acquire no more assets
and cannot make higher profits.

It can be relatively easily shown that both earnings growth and dividend growth is given
by:

g = bR

where b is the proportion of earnings retained andR is the rate that profits are earned on
new investment. Therefore, (1 – b) will be the proportion of earnings paid as a dividend.
Note that the higher b is, the higher is the growth rate: more earnings retained allows
more investment to that will then produce higher profits and allow higher dividends.

So, if earnings at time 1 are E1, the dividend will be E1(1 – b) so the dividend growth
formula can become:

P0 = D1 /(re – g) = E1 (1 – b)/(re – bR)

If b = 0, meaning that no earnings are retained then P0 = E1/re, which is just the present
value of a perpetuity: if earnings are constant, so are dividends and so is the share price.

If we consider that the dividend policy is represented by b and (1-b), the proportions of
earnings retained and paid out, it looks as though the formula predicts that the share
price will change if b changes, but that is not necessarily the case as we will see below.

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Modigliani and Miller’s dividend irrelevancy theory

This theory states that dividend patterns have no effect on share values. Broadly it
suggests that if a dividend is cut now then the extra retained earnings reinvested will
allow futures earnings and hence future dividends to grow. Dividend receipts by investors
are lower now but this is precisely offset by the increased present value of future
dividends.

However, this equilibrium is reached only if the amounts retained are reinvested at the
cost of equity.

Example 1: earnings are all paid as dividend

Current position: Earnings = $0.8 per share (all paid out as dividend); RE =20%, the price
per share. would be

P0 = 0.8/0.2 = $4 (the PV of constant dividends received in perpetuity).

Example 2: earnings are reinvested at the cost of equity

So, what would happen if, from Time 1 onwards, half the earnings were paid out as
dividend and half retained AND re = R = 0.2 (meaning that the return required by
investors is the return earned on new investment)?

P0 = E1 (1 – b)/(re – bR)

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.2) = $4

So, no change in the share value, and so the dividends are irrelevant.

Example 3: earnings are reinvested at more than the cost of equity

For example, the company has made a technological breakthrough and invests the
retained earnings to make use of the enhanced opportunities. As you might be able to
predict, this piece of good fortune must increase the share price.

re = 0.2 (as before) and R = 0.3

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.3) = $8

In this case, the share price rises because the extra earnings retained have been
invested in a particularly valuable way.

Example 3: earnings are reinvested at less than the cost of equity

For example, the company invests the retained earnings in a way that turns out to be
poor. It has messed up. As you might be able to predict, this piece of bad luck or
carelessness must decrease the share price.

re = 0.2 (as before) and R = 0.1

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.1) = $2.67

In summary:

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 If the company retains earnings and uses those to ‘do more of the same’ then the
share price should not be affected.
If the company retains earnings and uses those to produce higher returns than
demanded by investors (and that could be through expanding current operations to
become more efficient and cost effective) then dividends should be cut as that will
increase shareholder value.
If the company retains earnings and uses those to produce lower returns than
demanded by investors (and that could be through keeping excess cash in the
bank, earning very little) then dividends should be increased to avoid the share
price falling. If the company can think of no good use for its earnings, it should
distribute them to shareholders who can then decide for themselves what to do with
them.

Practical considerations

As so often occurs, theoretical outcomes do not always match practical considerations.

So too with dividend irrelevancy. Perhaps this is because investors do not understand or
believe the theory or perhaps it is because, to derive the theory, simplifying assumptions
have to be made, such as the existence of perfect markets with no transaction costs and
perfect information.

The practical matters are:

Signalling. The announcement of a dividend is the release of a piece of publically

available information. The semi-strong form of the efficient market hypothesis says
that the share price will react to this information. The problem is: what signal does a
change in dividend give out and therefore how should share prices move? For
example, does a cut in dividend mean that the company is conserving cash
because it expects hard times or does it mean that the company sees a great
investment opportunity? There is inevitably information asymmetry as the directors
will almost certainly be in possession of information that is not in the public domain.
Almost always shareholders will be unsettled by abrupt changes in dividend policy.
Lack of trust in directors’ forecasts or justifications for dividend cuts. Really, this
point follows on from above. Directors might have been very open about a dividend
policy but if investors do not share directors’ optimism about the future success of
the company, the share price will be affected.

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 Investors’ preference for current consumption rather than future promises (the ‘bird
in the hand’ argument). Here, it is argued that a current dividend means that
investors have safely received cash. Whereas, if the dividend were deferred they
are at the mercy of future events and risks. This argument is very persuasive, but it
is incorrect. Market forces should mean that a share price has been correctly set for
the level of risk and returns made. If more cash is paid out as dividend the investor
has to decide how to invest that cash. It could be spent on another investment
which has higher returns and higher risk or on one where both returns and risks are
lower. In either case, diversified investors should be happy with the deal because
the capital asset pricing model states that extra risk is correctly compensated for by
extra returns.
The clientele effect. This idea suggests that investors buy shares that ‘suit’ their
needs. So, a pension fund will base much of its investment portfolio on its need to
produce income to pay to pensioners. It will therefore invest heavily in shares that
pay regular, relatively predictable dividends. Similarly, tax can affect investment
decisions if gains are taxed less severely than income. If a company abruptly
changes its dividend policy it will disturb investors’ carefully constructed portfolios
and investors will have to adjust their mix of shares incurring transaction costs. It is
sometimes argued that if a cut in dividend reduces an investor’s income, the
investor can sell some shares to manufacture ‘income’. Of course, this will again
incur transaction costs and different tax treatment.
Company liquidity. Irrespective of all the potential share price movements that a
change in dividend policy might cause, companies have to ensure that their liquidity
is sound and might have dividend reductions forced on them if they are to stay
solvent.
Borrowing covenants. Sometimes lenders put clauses in loan agreements which
limit dividend payments, for example to a certain fraction of earnings. This is the
lender trying to ensure that the loan is more secure. If less cash is paid as
dividends, liquidity might be better (though, of course, cash can still be consumed
on the purchase of non-current assets).
Legal constraints. No distributable reserves means no dividends.

Here is perhaps a good place to mention scrip dividends. These allow shareholders to
choose to receive shares as full or partial replacement of a cash dividend. The number of
shares received is linked to the dividend and the market price of the shares so that
roughly equivalent value is received. This choice allows investors to acquire new shares
(if they don’t need the cash dividend) without transactions costs and the company can
conserve its cash and liquidity. There can also be beneficial tax effects in some countries.

Dividend payment policies

Constant dividends: in this approach dividends are predictable but shareholders

might be dissatisfied if they see earnings rising but they are stuck will low dividends.
If a larger and larger fraction of earnings is retained, shareholders might begin to
question whether the company can find enough investment opportunities of the right
quality.

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 Constant growth: again, predictable and very attractive to shareholders. However,
the dividend growth rate might not match earnings growth rate.
Constant pay-out ratio: for example, (1 – b) = 25%. A clear and presumably logical
link between dividends and earnings. However, in some circumstances this policy
might produce signals that are mis-interpreted. Directors know that shareholders
prefer predictable dividends and shareholders know that directors know their
preference. Therefore, shareholders might interpret the cut as signalling that
earnings are poor and will not improve any time soon. If, however, earnings fall yet
the directors maintain the dividend, this is often interpreted as signalling that the fall
in earnings is temporary and the directors feel sufficiently confident in the
company’s future to maintain the dividend in absolute terms.

Dividends as residuals: relating back to what was covered in the first section of the
article, before paying dividends, directors should first spend earnings on
investments in the company that yield:

Investments that yield more than the cost of equity (this will increase
shareholder value)
Investments that yield the cost of equity.

Only after these investment opportunities run out should the company pay dividends from
the residual earnings, thus allowing shareholders to make the best use they can of their
receipts.

No dividend: Microsoft and Apple both went many years without paying a dividend.
It is difficult to use the dividend valuation model in these circumstance without
making very contentious assumptions about what future dividends might be.
Nevertheless, share values rose dramatically as both companies were immensely
successful and, on a P/E approach to valuation, they were plainly very valuable
indeed.

Conclusion

Dividends and dividend policy will be a continuing cause of debate and comment. The
theoretical position is clear: provided retained earnings are reinvested at the cost of
equity, or higher, shareholder wealth is increased by cutting dividends. However, in the
real world, where not necessarily all investors are logical and where transaction costs and
other market imperfections intervene, determining a successful and popular dividend
policy is rather more difficult.

Ken Garrett is a freelance writer and lecturer

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