Dividend Policy and Share Price - Essay Example

Dividend Policy: Dividend Policy Can Affect Listed Companys Share Price. There are different types of investment options available to every investoracross the globe but the sole aim of every investment is common- To generate maximum possible return with limited employed capital. When share holders invest their money in the stock of a company, it becomes the responsibility of the management to provide them maximum returns on their investment. With the help of the capital accrued from various shareholders, the company subsequently enters into a predefined business, and tries to generate maximum possible profit. The excess liquidity obtained from the profits thus earned, after deducting the future operational costs, may be distributed to the shareholders in the form of dividend. However, whether dividends can create a value for shareholder is questionable as the excess liquidity, passed onto the shareholders, can be used to generate further profits subsequently improving the market price for the share and contributing to the investors’ wealth. The decision of whether to provide a dividend or not is therefore always based on maximizing the returns for the investors. In the course of the paper therefore we will see that whether paying dividend has any effect on the share price of the company thus affecting the wealth of the investors. The value of any company at any particular time is calculated with the help of its market capitalisation. Market capitalisation of the company is obtained by the formula:- Market Capitalisation= No. of Shares Listed * Market Price of single share. Theoretically, providing dividends to the share holders in the form of cash is dragging out the money available in the firm and therefore the market capitalisation of the firm should reduce by the same amount as the total dividends given. Because the market capitalisation is directly related to the share price, if we keep the number of listed shares to be constant for the company, the price for share must face an appropriate market correction after the dividends record date, which is in accordance with the theory suggested by Porterfield. As suggested by Porterfield (1959), if a company XYZ whose stock is worth $10 gives a dividend of $2 then ideally, the stock price should come to $8. In an ideal world, where there is neither tax nor any other restriction, the cash dividends would have no impact on shareholders’ value (Miller and ModiGliani, 1961). Empirical studies however showed mixed evidence, using the data from US, Japan and Singapore markets. A number of studies found that stock price has a significant positive relationship with the dividend payment [Gordon (1959), Stevens and Jose (1989), Ariff and Finn (1986), and Lee (1995)], while others found a negative relationship [Loughlin (1989) and Eastonand Sinclair (1989)]. Before we have a look at the factors which affect the dividend of the company, we must give a list of few factors involved with the firm in deciding the dividend policy which are:- 1. Legal Constraints. 2. Contractual Constraints 3. Owner Consideration 4. Market Consideration 5. Tax Considerations A company can pay dividends in either of the two ways:- 1. Cash Dividend 2. Stock Dividend In both the cases mentioned above, in ideal market, there should be no consequence of the dividend declaration. The former has been discussed earlier whereas in the case of the latter, the market generally makes the requisite correction. If a company XYZ declares a share dividend of 1:1 (i.e. 1 extra share for every single share held) and the current market price is $10 then after the record date, the share price must ideally come to $5 keeping the market capitalisation as constant. The important factors which specify the dividend policy of a firm are:- 1. Payout – High/Low 2. Whether a formal policy on stable dividend has been drafted 3. Stock dividends The primary objective of the dividend policy is to decide upon the excess liquidity and distribute it to the shareholders. For the money that it thinks it can generate a handsome return on, should not be distributed and thus be employed to generate more wealth for the investors. We take an example based on the payout of the company. Take two hypothetical companies A and B, A with a high payout policy of 80% whereas B with a low payout policy of 20%. Future projects of Company A:- Projections for company B:- This signifies the magnitude by which the equity price can vary because of the dividend policy. While the equity price of B is 1677.65 at the end of 20 years, it is just 210.68 for the company A. Moreover even the absolute dividend earnings are greater with B, owing to higher equity capital. Berkshire Hathways, the organization owned by the greatest investor on earth Mr. Warren Buffet believes in the same concept of not diluting its liquidity in the form of dividend but multiplying the wealth of their investors by utilizing in an apt manner. Berkshire has just given dividends to its share holder once in a span of forty years for which too Buffet remarks that the dividends might have been declared when he was in bathroom. But the amount of wealth that Berkshire has created for its stock holders is exemplary. The share price which was approx. $20 in 1965 is quoting as high as $80,000 as on Feb 19, 2009, which indeed is humungous return by any standard. Berkshire Hathways has given an annual compounded return of more than 21 percent continuously over a span of 43 years. However, the dividend declaration is not necessarily negative news. It signifies that the company is having enough faith on its future cash flows which is to be reflected in market price of the stock whenever the dividend increases [Bhattacharya (1979) Bar-Yosef and Huffman (1986) and Yoon and Starks (1995)]. When a stable policy regarding the dividend has been drafted, it affects the perspective of the investors through informational content. A stable dividend suggests that the company is expecting a smooth flow of income which is decisive in obtaining a good premium. Moreover the institutional investors are reportedly seen to be much more interested with these scripts increasing the demands and thus the price for such stocks. Stock Dividends also play a decisive role in marking the wealth of an investor. Although ideally the market price should be adjusted at par in accordance with the stock dividend offered by the company, but chances of the investor’s wealth to grow is primarily because the stock comes in a better trading range owing to a reduction in net price, triggering more demand. Moreover, it comes with a news flow on its side thus creating this aberration. As a general belief, dividend payment generates cash flow for investors but it puts a cap on a firm’s resources for investment. Hence, organizations should pay dividend only if they are not able to divert the excess money to generate suitable profits. Uddin (2003) in his study of 137 companies listed on Dhaka Stock Exchange (DSE) found that investors are not benefitted from dividend announcement. As per his study, within a duration of 30 days prior to dividend announcement to 30 days after the announcement of dividend payment, investors incurred losses up to 19.52 percent of stock value. Although the loss had been compensated partially by dividend yield, the net effect of dividend announcement was not positive. Here is a graph of Cumulative abnormal return of 137 DSE listed companies presented by Uddin (2003). We therefore conclude that although theoretically there is no effect of dividend declaration on stock price, but practically it does have a significant impact on stock price. Therefore the investor’s should do proper research on the kinds of dividends offered from the company in the past and should invest in organizations which is better suited to their investment profile. References: Ariff, M. and Finn, F. J., “Announcement Effects and Market Efficiency in a Thin Market: An Empirical Application to the Singapore Equity Market”, Asia Pacific Journal of Management, Vol. 6, 1986, p: 243-267. Bar-Yosef, S. and Huffman, L., “The Information Content of Dividends: A Signalling Approach”, Journal of Financial and Quantitative Analysis, Vol. 21, No. 1, 1986. Bhattacharya, S., “Imperfect Information, Dividend Policy, and ‘the bird in the hand” Fallacy”, The Bell Journal of Economics, Vol. 10, No. 1, 1979, p: 259-270. Easton, S. A. and Sinclair, N. A., “The Impact of Unexpected Earnings and Dividends on Abnormal Returns to Equity”, Accounting & Finance, Vol. 29, 1989, p: 1-19. Gordon, M. J., “Dividend, Earning, and Stock Prices”, The Review of Economics and Statistics, Vol. 41, 1959, p: 99-105. Kennon, Joshua. (2001). Warren Buffet Biography: Taking Control of Berkshire Hathaway. About.com. Retrieved 14 February, 2009, from http://beginnersinvest.about.com/cs/warrenBuffettt/a/aawarrenbio_3.htm Lee, B. S., “The Response of Stock Prices to Permanent and Temporary Shocks to Dividends”, Journal of Financial and Quantitative Analysis, Vol. 30, 1995, p: 1- 22. Loughlin P. H., “The Effect of Dividend Policy on Changes in Stockholders’ Wealth”, A PhD Thesis, Graduate School of Saint Louis University, 1982, USA. Miller, M. H., and Modigliani, F., “Dividend Policy, Growth and The Valuation of Shares”, The Journal of Business, Vol. 34, 1961, p: 411-433. Stevens, J. L. and Jose, M. L., “The Effect of Dividend Payout, Stability, and Smoothing on Firm Value”, Journal of Accounting Auditing & Finance, Vol. 7, 1992, p: 195-216. Porterfield, J. T. S., “Dividend, Dilution, and Delusion”, Harvard Business Review, Vol. 37, 1959,, p:56-61. Uddin, Md. Hamid. (2003). Effect of Dividend Announcement on Shareholders’ Value: Evidence from Dhaka Stock Exchange. Retrieved 05 March, 2009, from www1.fee.uva.nl/fm/Conference/Hyderabad/Uddin.pdf Yoon, P. S. and Starks, L. T., “Signaling, Investment Opportunities, and Dividend Announcements”, The Review of Financial Studies, Vol. 8, 1995, p: 995-1018 Read More