The Optimum Dividend Policy

A dividend is the distribution of value to shareholders (Shanken and Tajirian, 1997), which tends to be paid annually or bi-annually. Without any future dividend income for shareholders, the value of the company is essentially zero. It is these expected future cash flows which provide value to the shares. However, companies face a common problem of deciding on the optimum dividend to pay out to shareholders. It is the dividend policy of the company which answers this question. This blog will explore the optimum dividend policy for companies to possess, assessing whether shareholder wealth can be enhanced by altering the pattern and size of the dividend payments over time.

I suppose initially the company has the option of paying a high dividend or low dividend relative to earnings. Paying a low dividend would arguably give the company more cash to invest into new products, which in turn could increase shareholder wealth in the long term. Paying a high dividend does not allow for this, as the company will have less cash available to invest into new projects. Whilst this is true, shareholders do not have access to internal information and may therefore assume a low dividend reflects bad news and a high dividends reflects good news. As a shareholder, I would prefer a low dividend as I believe this allows for shareholder wealth to be maximised as the business can invest in new projects to increase potential future earnings, however I believe this needs to be communicated correctly to the shareholders to ensure they are aware that this is the direction that the business is taking and thus maintain a reasonable share price.

The second option the company has is the option of paying stable or fluctuating dividends. Fluctuating dividends would refer to altering the dividend amount depending on the level of earnings whereas stable dividends would refer to paying a similar level of dividends regardless of that period’s earnings. A fluctuating dividend is likely to allow the company more control of their finances as they can assess their earnings and then determine the optimum dividend payments. A stable dividend could prove the company problems in period’s where earnings may not be as high as expected as they may not has the cash available along with the company being left with excess cash in times of high earnings. However with stability, shareholder will know what they are due to receive which essentially lowers risk and uncertainty. As a shareholder I would personally prefer fluctuating dividends as I believe that this provides the business with more flexibility to maximise shareholder wealth, however if stable dividends would maintain a high share price due to reduced uncertainly then obviously this is more ideal.

Whilst these considerations have been discussed, Miller and Modigliani (1961) argue that in fact dividend policy is irrelevant to share value. They argue that share price is in fact determined by future earnings potential through the availability of projects with positive NPV’s and therefore the pattern of dividends makes no difference. Essentially they state that dividends represent a residual payment which is made after all projects with positive NPV’s have been undertaken. Whilst this argument makes sense, it is based on a number of assumptions such as investors having access to all relevant information, no taxes, no transaction costs and an indifference in preference between dividends and capital gains for example. In my opinion, in the real world, such assumptions are not the case and in fact not only do investors have different views, along with having to consider a number of costs such as tax and transaction costs, but investors are short sighted and therefore would rather money now in dividends than have to wait based on potential future earnings.

Overall as a shareholder, I have a mixed view on the issue of dividend policy. Personally, I would rather low dividends so that the company can invest funds to maximise future returns. I would also prefer fluctuating dividends so that the company can assess earnings and base dividends around these, again to maximise my wealth. However I believe that investors in general would not support these views as most investors are short sighted and want relatively high, stable returns. Therefore overall, even though beneficial to the shareholder, I believe low fluctuating dividends would actually destroy share value due to a lack of demand for the shares. Therefore in order to maintain an optimum share price along with maintaining the potential for high future returns, I believe that the best dividend policy would be for firms to provide investors with stable dividends along with a stable growth in the size of these. I believe this would attract investors though secure dividend payments along with allowing for a reasonable level of investment, to grow shareholder wealth in the future.

References in this blog

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-433.

Shanken, J., & Tajirian, A. (1997). Equity Factors and the Market Portfolio. Unpublished manuscript, University of California, Berkeley.