By: King Adawu Wellington (email: email@example.com)
People invest for a reason; some are interested in huge gains while others are focused on stable income that can support their lifestyle. In the capital market, shareholders receive cash from companies through dividends pay-outs after profits are declared or during share repurchase exercises. Dividends can also be paid with stock instead of cash – the implication with such a move is that total number of outstanding shares will increase. In general, most people – ordinary citizens – prefer dividend pay-outs comparatively to selling off their shares either through buybacks programs or simply trading.
There are various theories that are used to explain dividend pay-outs and its effect on shareholders. For instance, the dividend irrelevance theory emphasizes the independence of dividend pay-out policies, thus it states that there is no link between dividend policy, firm value and share price in a perfect market. Again, the bird in the hand theory states that investors prefer receiving regular dividends compared to capital gains. Also, the signalling theory deals with how investors perceive a firm’s future potential based on changes in dividend paid over time. Then there is the catering theory that states that “managers tend to initiate dividends when investors put a relatively high stock price on dividend payers, and tend to omit dividends when investors prefer nonpayers,” according to Baker and Wurgler. Simply put, managers take action based on the difference between the current stock prices of payers and nonpayers.
There is yet another theory that simplifies the debate of whether paying more dividends is good for shareholders. That is, the agency theory. According to this theory, because agency problems exist in almost every company, it can be argued that paying dividends leaves shareholders in a better position because it somehow decreases agency problems in companies thereby creating value for shareholders. The rationale is that where agency problems exist, business managers are likely to execute their own interest instead of working to increase shareholders wealth. Also where there are personal interests involve, cash is likely to be misused on unprofitable projects because of “kickbacks” and this leaves shareholders disenfranchised. This line of argument supports the reason why dividends pay-outs are better for shareholders.
If you consider the issue of taxation then another line of argument can be made to favour capital gains instead of dividends pay-out. This is because, there is a general school of thought that dividends attracts higher taxes compared to capital gains hence the more dividends paid by firms, the more taxes shareholders pay on what they get therefore shareholders are better off with less dividends and more capital gains. But the assertion above does not apply to every country because issues of taxes are country specific.
There are advantages and disadvantages of paying or not paying dividends. For instance, paying fixed dividends result in stock price increase because investors perceive the company’s performance to be positive. However it makes retains earnings not to be constant and this can affect the firm’s ability to grow. Be mindful that growth is also linked to a company’s value and shareholders’ wealth.
Furthermore, not paying dividend is also less favourable to investors but might result in increase of firm value and maximization of capital gains if those managing the firm are able to grow the business overtime. A classic example is S&P 500 companies such as Facebook Inc. and Alphabet who for a period were not paying dividends but rather maximized firm value overtime. Now, this resulted in increase in shareholders’ wealth because the share price increased. However, continuously paying dividends year-on-year results in shareholders receiving steady income but this might curtail a company’s ability to maximize value because they may not be reinvesting into the business to ensure growth hence shareholders’ wealth might be affected in the long-term.
The interesting thing about this discussion is that irrespective of what you agree with, you are right because there is no wrong or right answer to the question. This is because dividend pay-out policies should not be generalized. It must be based on your company’s size, profitability, solvency, growth, industry and factors peculiar to the company. Hence, an argument cannot be emphatically made that the more dividends paid by firms, the better for shareholders because it depends on a lot of factors.
About the writer:
King Adawu Wellington is a business strategist with expertise in executing projects and helping companies achieve their goals in diverse industries.