FM Technical Article Podcast: Dividend thoery

Dividends and share price growth are the main ways of providing wealth to shareholders. Companies must decide what portion of earnings to pay out and what to retain, as retained earnings fund growth.

Theories

• Dividend Valuation Model
 • Share value is based on expected future dividends.
 • Formula: P0 = D1 ÷ (re – g)
 • D1 = dividend at Time 1, re = cost of equity, g = expected growth rate

• Gordon Growth Model
 • Growth arises from reinvesting retained earnings.
 • g = b × R (b = proportion retained, R = return on retained earnings)
 • Dividend at Time 1: D1 = E1 × (1 – b)
 • P0 = E1 × (1 – b) ÷ (re – b × R)

• Modigliani & Miller Dividend Irrelevancy
 • Dividend policy does not affect share value if retained earnings earn the cost of equity.
 • Higher returns on retained earnings increase share price; lower returns decrease it.

Practical Considerations

• Dividend announcements signal company health; abrupt changes may unsettle investors.
• Investors may prefer current dividends (‘bird in hand’), though CAPM shows risk-adjusted returns compensate.
• Clientele effect: investors choose shares based on income needs; sudden changes disrupt portfolios.
• Liquidity, borrowing covenants, legal limits, and scrip dividends also influence policy.

Dividend Policies

• Constant dividends – predictable, but may frustrate shareholders if earnings rise.
• Constant growth – stable growth, may differ from earnings growth.
• Constant pay-out ratio – linked to earnings, may send unintended signals.
• Residual dividends – pay only after investing in projects yielding ≥ cost of equity.
• No dividend – some companies (e.g., Microsoft, Apple) initially reinvest all earnings, increasing share value.

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