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.
The relevant theories are:
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)
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.
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.
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:
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.
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
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:
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.
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.
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