Bird-In-Hand And Dividend Irrelevance Theories

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A bird-in-hand is worth two in the bush ~ anonymous

This is how dividend investors see the market. Having the cash payout is better than the company retaining the earnings for growing the business. The latter is full of uncertainty as the company may eventually collapse and the investors get nothing. The point is get the money first!

It was Myron Gordon and John Lintner who came out with this bird-in-hand theory. It proposes investors prefer dividends to capital gains. Capital gains are more risky and investors expect to be compensated by higher returns, which means it puts pressure on the management to deliver higher growth in the future, which may or may not happen. To the company, the cost of holding the retained earnings is actually higher than distributing it away. With higher cost of capital, it is less competitive to a similar company which gives away the dividends, and the stock price should come down to reflect lower profits (due to higher cost).

Hence, they believe the dividend returns and the future growth rate of the dividends are the total returns to the investors. If true, the value of a stock can be determined by the Gordon Growth Model,

Value of the company = (expected dividend one year from now) / [ (required rate of return of the investor) – (dividend growth rate) ]

The dividend effect has been studied by academia and the researchers could not agree with one another.

On the other hand, Franco Modigliani and Merton Miller proposed the dividend irrelevance theory, which states a company’s dividend policy has no impact on its cost of capital or on shareholder wealth.

Imagine a company gives out all its earnings as dividends. To finance a project, the company can issue new shares to raise money from the shareholders, and that would offset the value of the dividend.

This is exactly what we see with REITs. Having to pay out 90% of the earnings to investors, and limited by a cap to borrow money, REITs find it challenging to find fundings to expand their property portfolio. The usual way is to issue rights from time to time, clawing back money from the dividends they have distributed. Teh Hooi Ling, an ex-Business Times journalist, wrote an article about this a few years back and showed majority of the REITs have issued new units at some point in time.

It is also intuitive to understand that if a company’s stock price is $2 and it gives away $1 as dividends, the stock price will drop to $1, and there is no difference to shareholder’s wealth.

There are many other theories revolving about dividends. Another theory is that management of a company can issue dividends as a form of signalling. For example, if the company is suspected to face solvency issue, the management may distribute dividends as a show of financial strength within the company.

How I See It

I agree with Modigliani and Miller that there is no change in shareholder’s wealth regardless the company distribute the dividends or not.

But in reality, I find that people generally do prefer dividends than capital gains. And that preference can translate to higher demand for dividend paying stocks, and further translate to premium prices for these stocks. Jon talked about this behavioural inclination in this article. Which means I agree with Gordon and Lintner on the dividend preferential part.

I am basing my observations in Singapore where dividends are not taxed. In other countries, the dividend tax may be significantly higher than the capital gain tax, and that may result in more people investing for capital gains.

Ultimately, I just want to know the market consensus. In this case, I am concerned about the degree of valuation asymmetries between dividend-paying companies and companies that do not. I believe it is the collective preference in the stock market that tells us what to avoid since contrarians (some but not all) usually make the money. If I can establish that the majority of the market participants invest for dividends and result in premium stock prices for dividend-paying companies, I would definitely avoid them.

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Co-Founder. Believer of the Factor-based Investing approach. Running a Multi-Factor Portfolio that taps on the Value, Size, Profitability and Momentum Factors. Quant at heart. Believe the financial industry can treat their customers better. Wants to change the world.
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