How can a company's dividend policy impact its shareholders?

1 Dividend relevance theory

One of the main theories that explain the relationship between dividend policy and shareholder value is the dividend relevance theory. This theory, proposed by Franco Modigliani and Merton Miller, suggests that dividends are relevant for the valuation of a company, and that investors prefer higher dividends to lower dividends. The rationale behind this theory is that dividends reduce the uncertainty and risk of future cash flows, and signal the quality and profitability of a company. Therefore, a higher dividend payout ratio (the percentage of earnings paid as dividends) implies a higher share price and a lower cost of capital.

2 Dividend irrelevance theory

Another theory that challenges the dividend relevance theory is the dividend irrelevance theory. This theory, proposed by Merton Miller and Franco Modigliani, suggests that dividends are irrelevant for the valuation of a company, and that investors are indifferent to the dividend policy. The rationale behind this theory is that dividends do not affect the cash flows or the risk of a company, and that investors can create their own dividend policy by selling or buying shares. Therefore, the dividend payout ratio has no impact on the share price or the cost of capital.

3 Types of dividends

Different types of dividends may be paid to shareholders depending on a company's dividend policy and financial situation. Cash dividends are the most common, providing immediate income and liquidity, but also reducing retained earnings and the cash balance. Stock dividends increase the number of shares outstanding and reduce earnings per share, without affecting the total value or cash position. Special dividends, paid out of extraordinary profits or reserves, are usually larger than normal dividends and indicate a positive outlook for the company. However, they reduce retained earnings and the cash balance, and may not be sustainable in the long term. Dividend reinvestment plans (DRIPs) allow shareholders to reinvest their cash dividends in additional shares of the company at a discount, increasing ownership and compounding returns without transaction costs or taxes. But this also exposes shareholders to more risk and volatility due to share price fluctuations.

4 How dividends impact shareholders

The impact of dividends on shareholders is affected by multiple factors, such as the type of dividend, the dividend policy, the tax treatment, the market conditions, and the preferences and expectations of the shareholders. Dividends can provide a regular and stable source of income to shareholders that rely on them for their living expenses or investment goals. Furthermore, dividends can convey information about the current and future performance of a company and influence the perceptions and confidence of shareholders. In addition, dividends can attract or repel different types of shareholders depending on their preferences and expectations. Lastly, dividends can reduce the agency problem between managers and shareholders by limiting free cash flow that managers can use for their own benefit or for unprofitable projects.

5 How to evaluate dividend policy

As a shareholder, you may want to evaluate the dividend policy of a company, and how it affects your returns and risks. You can consider the dividend yield, which is the ratio of the annual dividend per share to the current share price. This measures the return from dividends relative to the price you pay for the shares. Additionally, you should look at the dividend growth rate, which is the percentage change in the annual dividend per share over time. This reflects the growth potential of earnings and cash flows of the company. Furthermore, consider the payout ratio, which is the ratio of annual dividend per share to annual earnings per share. This indicates the retention and reinvestment policy of the company. Lastly, examine the dividend coverage ratio, which is the ratio of annual earnings per share to annual dividend per share. This shows if a company can cover its dividend payments with its earnings and indicates its dividend safety and sustainability.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?