Some believe that a firm’s decision to pay dividend is subject to the weighted average of current earnings and past earnings. Thus, according to Lintner’s (1956) simple model, payment of dividend depends in part on the firm’s current earnings and in part on the dividend of the previous year, which in turn depend on that year’s previous earnings and the dividend in the year before, consequently, dividend payment depends on the weighted average of current earnings and past earnings. As such, mature companies with stable earnings; pay high proportion of earnings, while growth companies have low payout (if they pay dividends at all).
Also decision to pay dividend or not is often mixed up with either financing or investment decisions. Some firms pay low dividends or do not pay at all, because management is optimistic about the firm’s future and wishes to retain earnings for expansion. In this case the dividend is a by-product of the firm’s capital budgeting decision. Another firm might finance capital expenditures largely by borrowing, this releases cash for dividends. In this case the firm’s dividend is a by-product of the borrowing decision.
Albeit to above, different opinions have been theorized on whether or not dividend payment or not, increase or decrease affects stock price and firm’s value?
On the right, known as the conservative, believes that increase in dividend, increases stock price or firm’s value. They point out that there is a natural clientele for high-payout stock. For example some financial institutions are legally restricted from holding stocks lacking established records. Trust and Endowment funds may prefer high-dividend stocks because dividend are regarded as spendable “income” whereas capital gains are “additional principal”
On the left, known as radical group believes that increase in dividend payment reduces firm value. They argue that when dividend is taxed more than capital gains, firms should pay the lowest cash-dividend they can get away with. So, available cash should be retained for future profitable investment or used to repurchase shares. If dividend attracts more tax than capital gains, why should any firm pay dividend? If cash can be distributed to stock holders, then share repurchase is always the best channel for doing so? So the leftist called for not only for low payout but for zero payment especially when tax on dividend is heavily higher than tax on capital gains. However, it is important to note that the distinction between dividend and capital gains is less important for financial institutions. Many of which operate free of all taxes and therefore have no reason to prefer capital gains to dividend or vice versa. For example, pension funds are untaxed. Only corporations have a tax reason to prefer dividends. They pay corporate income tax on only 30% of any dividend received. Thus the effective tax rate on dividend received by large corporations is 30% or 35% (the marginal rate) or 10.5%. But they have to pay a 35% tax on the full amount of any realized capital gain.
At the centre, known as Middle-of-the-Roaders represented by Miller, Black and Scholes maintained that a company’s value is not affected by its dividend policy. They published a theoretical paper showing the irrelevance of dividend payment where there is a perfect market of no taxes, transaction costs or other market imperfections. They equally recognize the possible high payout clientele group, but argue that they are satisfied also. On the argument on higher payout being discouraged by high taxes, the middle-of-the-roaders are of the view that there are plenty of wrinkles in the tax system which the stockholder can use to avoid payment of taxes on dividend. For example instead of investing directly in common stocks, they can do so through pension fund or insurance company which receives more favorable tax treatment. So company that pay low dividend will be more attracted by highly taxed individuals, while those that pay high dividend will have greater proportion of pension funds or other tax-exempt institutions as their stockholders. They argued that investors may not need dividend to get their hands on cash and as such will not be willing to pay higher prices for the shares of firms with high payouts. Therefore firms might not worry about dividend policy, but let dividends fluctuate as a by-product of their investment and financing decisions. Any increase in cash dividend must be offset by a stock issue, if the firm’s investment and borrowing policies are held constant. In effect the stockholders finance the extra dividend by selling off part of their ownership of the firm. Consequently, the stock price falls by just enough to offset the extra dividend. Also as expected switching from cash dividend to share repurchase has an effect on shareholder’s wealth. When shares are repurchased, the transfer of value is in favor of those who do not sell.
However, market consensus on expected dividend payment based on earnings can affect the stock value. For instance, in 2017, Total Nigeria Plc recommended a final dividend of N17 per share for the year ended December 31, 2016 to be paid from PAT of N14.769 recorded in the year, a 265.5% increase from N4.1 billion recorded in 2015 to N14.769 billion recorded in 2016. Based on the result, the market reacted negatively as the shares fell by 5.4 per cent to close lower at N274.55 each.
Analysts believe that the final dividend recommended by Total Nigeria was below market consensus given the strong earnings growth recorded. This works out to a dividend payout of just 39 per cent, the lowest in over two decades.
What then is the impact of payment or non-payment of dividend on the value of the stock and the wealth of a company? When you buy stock, there are two income streams expected – dividend and capital gain and the value of the stock is the present value of the dividend and stock price discounted at appropriate discount rate. You can use Gordon growth model, two-stage or three-stage dividend discount model to value the stock, but what is important is what you want to achieve; to detect if the stock is under or over-valued and why. For instance, Gordon growth model, which depends on three key factors, future dividend, cost of equity and expected growth rate is best suited for firms growing at a rate comparable to or lower than the nominal growth in the economy and which have well established dividend payout policies that they intend to continue into the future. The dividend payout of the firm has to be consistent with the assumption of stability, since stable firms generally pay substantial dividends. In effect, the model, underestimates the value of stock in firms that consistently pay out less than they can afford and accumulate cash in the process.
Idika Agwu Aja