One of the jobs of a corporation’s board of directors is to set dividend policy, which involves the timing and amount of dividends to pay. Academics are divided on the effects of dividend policy. Some say that dividends are important in attracting investors and supporting stock prices, while others claim that earnings are just as important as dividends. Empirical evidence, while not uniform, does suggest that higher dividends raise stock prices, while dividend cuts hurt prices. Other studies show that higher dividend payments make stock prices less volatile.
The accumulated profits of a firm are recorded in the retained earnings account of stockholders’ equity, which is the surplus of assets over liabilities. Retained earnings are the only source for dividend payments, whereas internal growth, in the form of new projects, asset purchases, etc., can be financed using retained earnings, new issues of stock, and/or with debt. Cash dividends, if paid, are usually declared and distributed quarterly, Stock dividends are occasional distributions of additional stock to shareholders. The dividend yield is the annual dividend amount divided by the current share price.
Dividend Discount Model
The dividend discount model posits that the current stock price is equal to the present value of all future dividend payments. As the present value increases, stock prices rise. Thus, higher dividends translate directly into higher stock prices. There are problems with the model, however. It doesn’t explain the prices of non-dividend stocks, and it expects that the rate of capital gains growth will always be steady and not exceed investors' required rate of return, which is known as the cost of capital.
The Modigliani-Miller Theorem states that shareholders are indifferent to the division of retained earnings into dividends and new investments. If correct, it predicts that the amount of retained earnings spent on dividends, which raise stock prices, is offset by the effect of issuing new stock to replace the money spent on dividends, which lowers stock prices. The model doesn’t consider the use of debt instead of new stock issuance. The M-M Theorem concludes that dividend policy does not affect stock price.
The clientele effect is an acknowledgment that income-oriented investors are drawn to dividend-paying stock, while those who are less risk-adverse prefer capital gains. Thus, if a company makes substantial changes to its dividend policy, some shareholders will approve and may buy additional shares, while other shareholders will sell their shares and find others that are more to their liking.
This theory states that an increase in the dividend rate should be viewed as a vote of confidence by the corporation board about the company’s prospects to increase growth and earnings. If the board thought that the firm would be short of funds, it would cut dividends rather than raise them. Since board directors know the most about the company, the positive signals it sends should be viewed by investors as a reason to buy shares and thus raise share prices.
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