Expected Dividends, No Growth

Expected Dividends, No Growth

The Dividend Decision

Whether to issue dividends and in what amount is mainly calculated based on the company's unappropriated profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash flows, which means cash remaining after all business expenses and capital investment needs have been met.

If there are no favorable investment opportunities–projects where returns exceed the hurdle rate–finance theory suggests that management will return excess cash to shareholders as dividends. However, there are exceptions. For example, shareholders of a "growth stock" expect that the company will, almost by definition, retain earnings to fund growth internally.

At the other end of the spectrum, investors of a "no growth" or value stock will expect the firm to retain little cash for investment and to distribute a comparatively greater proportion to investors as a dividend.

Clientele Effects

This suggests that a particular pattern of dividend payments may suit one type of stockholder more than another; this is sometimes called the "clientele effect." A retiree may prefer to invest in a firm with a consistently high dividend yield. In contrast, a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income.

Suppose clientele exists for particular patterns of dividend payments. In that case, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

Value Investors

If there is no growth, high-dividend stocks may appeal to value investors. Value investing involves buying securities with shares that appear underpriced by some fundamental analysis. For example, such securities may be stock in public companies with high dividend yields, low price-to-earning multiples, or low price-to-book ratios. Thus, high dividends and low reinvestment of retained earnings can signal an appealing value stock to an investor.

I nvesting trade-offs: Value investors trade growth for dividends .

Key Points

• Companies generally either retain earnings for investment, or distribute them as dividend, according to their growth strategy.
• Clientele effects suggests that different dividend levels attract different types of investors.
• Value investors look for indications that a stock is undervalued. High dividends are one indication of undervaluation.
• Knowing a firm's cost of capital is needed in order to make better decisions. Managers make capital budgeting decisions while capital providers make decisions about lending and investment.

Term

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