Oct 31, 2011 0
Does a company’s decision regarding its dividend distributions have an impact on the value of its equity? In short, do dividends
Dividends are irrelevant
In terms of classic finance theory, a rational investor should be indifferent between receiving a cash dividend from a share, or having the company retain the cash and re-invest it at the weighted average cost of capital. In this way, a stock trading at 10/share cum dividend (meaning the dividend belongs to the buyer of the share and not the seller) would trade at R9/share ex dividend (meaning the dividend belongs to the seller of the share and not the buyer), once the R1/share dividend has been paid, and the investor would be equally happy holding the R10 share without the prospect of a dividend. This school of thought, known as the dividend irrelevance proposition, has strong theoretical backing in a world where taxes are ignored, securities are fairly priced, and the cost of issuing new stock is negligible. An investor is indifferent to receiving returns in the form of dividends, stock appreciation or a combination.
Dividends do matter
However, in practice, the relationship is not always so simple. Several asset managers have stated their preference for dividend paying shares, as it is often indicative of a company which is stable and has matured to the point where sufficient free cash flow is being generated to justify a cash distribution. Certain types of investors, such as pension funds, have a need for regular distributions (to cover either administration costs or the monthly income needs of its clients, especially the elderly) and have a
preference for dividend paying stocks. The market often takes a dim view of companies which are sitting on large cash reserves, especially where management has neither a credible plan for the investment of the funds nor the intention to return the funds to shareholders. It is not uncommon for management teams in this position to squander excess cash resources on overpriced acquisitions, or ventures not related to the core business of the company.
Investors prefer a consistent (and preferably increasing) regular dividend pattern, and building up a good track record in this respect can help a company achieve confidence in the management team which translates into an increased share price. Indeed, accounting earnings can be manipulated but cash dividends are cash. The level of the dividend payout ratio would typically be determined after examining the stage of the company’s life cycle. Mature, established business would have far higher dividend payout ratios than start-up or fast growing companies (which may not pay dividends at all for several years).
In industries which are cyclical or in the event that an unusual gain is realised by the company which is unlikely to be repeated, it
makes sense to return the surplus funds to shareholders by manner of a special dividend. The occasional use of a special dividend allows the company to maintain a consistent regular dividend history, without sacrificing the flexibility of maintaining an optimal capital structure.
Several companies which had historically been consistent regular dividend payers and decided to forego or reduce such a dividend (BP and Anglo American come to mind), have seen their share price decline following such an announcement, not necessarily because of the cash retention but rather the signal sent to the market that senior management and the directors foresee difficult times ahead and are choosing to retain the cash. This uncertainty about the future translates into a weaker share price. Dividend policy may send a signal to the market which is more powerful than the actual amount of dividend paid (or withheld), because management and the directors are the ultimate company insiders. They have intimate knowledge about the company’s affairs, and are thus effectively communicating non-public information by their dividend decisions.
Total shareholder return
According to Standard & Poor’s, the dividend component was responsible for 44% of the total shareholder return of the last 80 years of the index. Our internal research reveals that, measured over a 10 year period on the JSE, the equivalent statistic is 36% in dividends.
Thus, to the investor, dividends constitute a significant portion of their investment return.
Empirical studies have not provided a conclusive link between dividend policy and valuation. The chief consideration in determining a suitable dividend payment policy should be the availability (or lack) of suitable reinvestment opportunities which have a positive net present value (NPV). If such opportunities exist, the company should reinvest its surplus funds into these projects, failing which the cash should be returned to shareholders by way of a dividend. As an alternative, a share buy-back could also be considered if the company’s shares appear undervalued.