Dividend policy
is “the determination of the proportion of profits paid out to shareholders – usually
periodically” (Arnold, 2013). According to Portfield (1965) the aim of the dividend policy
is to maximise shareholder wealth. To do so, the new share price should be
equal to, or be greater than the previous share price. In comparison,
Modigliani and Miller (1961) (M&M) argued that dividend policy is
irrelevant to share value (with the assumptions that were mentioned in my
previous blog). Their theory suggests that the determination of value is determined
by future earning potential; and the pattern of dividends makes no difference
to the acceptance of these. This indicates that the share price of a company
would not change if the company declared a zero dividend policy or a policy of
high near-term dividends (Baker, Powell and Veit, 2002).
Lets look at an example to
illustrate this theory:
If this theory were to be
true, then Morrisons share price would show no change when the Chairman
announced on the 6th March 2015 that the supermarket was cutting its
dividends to help fund the turn around plan (The Telegraph, 2015). Figure 1
which I have created, shows that the share price was uneffected by this
announcement. Although the market is not ‘perfect’ how M&M (1961) assumed, what
this example does demonstrate it that
when investors are aware that the cash retained will be going into a postive
NPV project which will generate future dividend increases for shareholders, the
share price is uneffected. However, some shareholders require dividends as a
source of regular income, therefore Morrisons may see a decrease in a certain
clientelle of shareholders (Watson and Head, 2013). Shareholders could sell a
proportion of their shares to create ‘homemade dividend’ confident in the
knowledge that a fair price would be obtained in this ‘perfect world’, which
takes into account the additional value from the project (Arnold, 2013). Of
course, as addressed in a previous blog, a perfect capital market does not
exists, as transaction costs and taxes are very much real, therefore this
theory is arguable inaccurate.
Figure 1: Share Price of
Morrisons. Figures from Yahoo Finance, 2015
M&M (1961) also argue that dividends represent a
residual payment. Using the Morrisons example to illustrate, once Morrison's have provided funds for the turn around plan, investors should be given the residual. By receiving this cash, they can invest in other organisations of the
same risk class which provide an expected return at least greater as the
required return on equity capital (Arnold, 2013).
In this circumstance dividend policy becomes an
important determinant of shareholder wealth:
- If cash flow is retained and invested within Morrisons at less than the equity capital, shareholder wealth would be destroyed; therefore it would be better to raise the dividend payout rate
- If retained earnings are insufficient to fund the positive NPV turn around plan, shareholder value is lost, and it would be beneficial to lower the dividend.
In contrast, Gordon (1959) presented the “bird in the
hand”argument which indicates that dividends are preferred to capital gains due
to future uncertainty. As an investor, I would rather have my money now, than
to leave it tied up in uncertain investments. With this in mind, it is clear to
see that the dividend policy will influence the market value of a company.
Now lets look at an example to illustrate this opposing
theory:
On February 6th 2015, Norway’s
Statoil announced that it would cut capital spending by $2 billion this year in
preparation for an ‘extended period’ of low prices and volatility (Bloomberg,
2015). This announcement came after Statoil published that the net income for
the quarter was $9 billion which was drastically lower than their estimations
of $26 billion. However, the new CEO, Eldar Saetre ensured shareholders that
the company is still “highly committed to the dividend policy”. The dividend
rate will remain at a flat for the next 3 quarters, which he believes reflects the
current market environment whilst remaining competitive (Bloomberg, 2015).
If Statoil are facing tough
times, then why are they committed to their dividend policy? From a business
point of view, the answer is simply. If Statoil had decided to pay a lower
dividend, then their investors may sell their shares and invest in one of their
competitors which are paying a higher dividend. This would result in a decrease
in Statoil’s share price and therefore decrease the market value of the company
(Watson and Head, 2013). What Statoil is doing is ‘signalling’ good news to their
shareholders. The competitive dividend pay out is acting as an important conveyor
of information (Arnold, 2013). Due to information asymmetry within the market,
dividends are used as an indicator of a firm’s sustainable level of income. Even
when faced with uncertainty regarding the price of oil, Statoil are indicating
an optimistic view about their future, which should therefore not reduce investor’s
confidence in the company. By looking at Figure 2, it is clear that this approach
has been successful, as Statoil have been able to maintain a reasonable steady
share price since the announcement.
Figure 2: Statoil’s
share price for the first quarter of 2015. Figures from Statoil, 2015
In comparison to M&M’s
theory, as an investor I would be slightly concerned that by continuing to pay competitive
dividends that Statoil may have limited positive NPV projects therefore may
lower my future returns (Watson and Head, 2013). However, Saetre has clearly communicated
that the company will continue to stay on track with its giant Johan Sverdrup
field and other ongoing projects. I believe that by addressing shareholders’ concerns
on Bloomberg Television’s “Countdown” demonstrates transparency therefore shareholders
know exactly where they stand with Statoil’s future, which had also influenced
the steady share price.
In conclusion, although M&M’s
(1961) theory is criticised due to assumptions that were made, I agree that in
order for Morrison’s to make an effective turn around, dividends need to be
reduced so there can be a concentration on investing in positive NPV projects. By
thinking long term, this should increase shareholder wealth. However, if there
is a residual once all projects have been covered, then I believe that the
shareholders should receive that money. By illustrating this theory with the Morrison’s
case, it demonstrates that when shareholders are aware of what the reduction in
dividends are being invested in, then the share price remains relatively
steady. Likewise, by effectively communicating what their plans are, Statoil have
been able to maintain shareholder confidence which has resulted in a steady share
price. Although they have not reduced their dividend policy, the recently
published results could have affected the share price of the company, had they
not effectively communicated their future plans and signalled a positive view
for the future.
References
Arnold, G. (2013). Corporate Financial Management. (5th ed.), Harlow: Pearson.O’Brien
Baker, H. K., Powell, G. E., & Veit, E. T. (2002). Revisiting the dividend puzzle: Do all of the pieces now fit?. Review of Financial Economics, 11(4), 241-261.
Bloomberg (2015) Statoil CEO Says `Highly Committed' to Dividend Policy. Retrieved from http://bloomberg.com
Gordon M (1959), “Dividends, Earnings and Stock Prices”, Review of Economics and Statistics, 41, 99- 105.
Miller, M. H., & Modigliani, F. (1961). Dividend
policy, growth, and the valuation of shares. the
Journal of Business, 34(4),
411-433.
Porterfield, J. T. (1967). Dividend Policy and Shareholders' Wealth. Financial Research and Management Decisions, hg. von Alexander A. Robichek, New York, London, Sydney, 54-67.
The Telegraph (2015) Morrisons to slash dividend to
fund rescue plan. Retrieved from
Watson, D. & Head, A.
(2013). Corporate Finance:
Principles and Practice. (6TH ed.), Harlow: Pearson.
Figure 1 - Figures from Yahoo Finance. Retrieved from https://uk.finance.yahoo.com/echarts?s=MRW.L#symbol=MRW.L;range=1d
Figure 2 – Figures from StatoIl. Retrieved from http://www.statoil.com/en/investorcentre/share/pages/historicshareprices.aspx
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