Blog 6

Do Dividends create Shareholder Value?

Companies which issue dividends will decide how much to pay their shareholders with a dividend policy. A dividend is a portion of the company’s earnings decided by the board of directors and they can be in the form of cash, stock or property, which are paid to investors on a quarterly or semi-annual basis. It is often seen that companies which offer shares and dividends tend to be the most secure and stable, though as we have seen recently with the Tesco profit scandal, that shareholders are willing and prepared to sell their shares as soon as something like that happens.

Dividend decisions are influenced, to some extent, by investment and financing decisions because if there are no attractive investments for the company, they may decide to increase dividends. On the other hand, if finance is a problem for the company, perhaps they will lower the dividends instead.

In the UK, dividends are paid out twice a year:

·         Interim dividend which is paid during the year

·         Final dividend which is paid after shareholder approval at the annual general meeting, and these dividends may be more than the interim dividends because final year results are available and so they know how much they can pay out.

Dividend policy should aim to maximise shareholder wealth. Porterfield, 1965, argued that this could only be achieved if P1+D≥ P0

Dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share, and it is a staple of the capital asset pricing model which, in turn, is the basis of corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, 'discounted back' to their net present value. As dividends are a form of cash flow to the investor, they are an important reflection of a company's value. The model is based on the belief that the market value of ordinary shares represents the sum of the expected future dividend flows, to infinity, discounted to present value, according to Arnold 2008.

On the Contrary, there are some companies that do not pay dividends, for example Dell and Warren Buffett’s Berkshire Hathaway. The reason why companies choose to do this is that they believe the funds are better used within the firm than if they were given to shareholders.

However, Modigliani and Millar, 1961, argued that share valuation is a function of the level of corporate earnings, which reflects a company's investment policy, rather than a function of the proportion of a company's earnings paid out as dividends. They also argue that only investment decisions are responsible for the future profitability of a company, hence share valuation is independent as it measures company's earnings, not dividend payments. M&M give the following assumptions, which make dividend policy irrelevant.

1. There are no taxes

2. There are no transaction costs

3. All investors can borrow and lend at the same interest rate

4. All investors have free access to all relevant information

5. Investors are indifferent between dividends and capital gains.

Given these assumptions, the determinant of value is the availability of projects with positive NVP’s; and the pattern of dividends makes no difference to the acceptance of these.

In the real business world, have placed great importance on dividends, suggesting they are very relevant in companies, who aim for stable dividends with stable growth.