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Dividends TA
Dividends TA
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
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.
P0 is the ex div market value. The formula is based on an investment costing P 0 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.
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.
P0 = D1 /(re – g)
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.
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 and R 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:
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.
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.
P0 = E1 (1 – b)/(re – bR)
So, no change in the share value, and so the dividends are irrelevant.
In this case, the share price rises because the extra earnings retained have been
invested in a particularly valuable way.
In summary:
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
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.
o Investments that yield more than the cost of equity (this will increase
shareholder value)
o 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.