Dividends

I have never really put much though into the issue of paying dividends, simply because I have believed it to be pretty straightforward process. An investor buys shares in a company and in return they receive a large pay out (dividends), simple yes? Regrettably not, after this weeks lecture I have once again had my eyes opened to the complex and arduous task companies face when dealing with issues of paying dividends.

Research carried out suggest that investors use dividend signals to assess a companies performance, and that stock returns are positively correlated by dividend fluctuations (Asquith & Mullins 1983 and Aharony & Swary 1980). Having said that it seems to me too presumption to assume that a change in a company’s dividend level means that there has been a change in performance or profitability?

I accept that in certain scenarios a decrease in dividends may lead to a lack of investor confidence, and that investors would argue that dividends are preferable to capital gains because of the fear of uncertainty. However this can be due to a miss-guided feeling that their future investment may get tied up in uncertain projects. Unfortunately we do not live in a ‘perfect world’, and managers are in possession of sensitive operational information that is not always made accessible to investors for fear company investment plans are made public knowledge. Whilst I understand that a degree of secrecy is needed, I do believe that there needs to be a bit of ‘give and take’ on both sides. Whilst investors do get to find out such information in annual reports, as they make a beeline to the page that is most concerning for them, I can’t help but think that there is a lack of trust between the two camps.

One reason for retaining residual income is to reinvest in future investments, investments that in the long-term will create higher returns and maximisation shareholder wealth. However if such projects are not fully communicated to shareholders carefully they can have an adverse affect. Due to this lack of insider information all investors can do is look to dividend levels to access company performance, with the basic assumption being: high dividend = good

                             low dividend = bad

However as discussed above, it’s not all black and which and in reality the reverse many be true: 

high dividend = lack of good investments and thus lower future investment returns.

low dividend = indication of attractive investments made and future prospects.

It could be argued that investors are too short sighted and that managers jeopardise potential long-term profit gains in favour of high dividend returns. Which in return contradicts the concept of shareholder maximisation when it is in fact the very same people who are preventing companies from doing so. It makes me think of the saying ‘all good things come to those who wait’ and questions whether there can ever be a happy medium. In order for companies to give high dividends they need to have made good investments in the first place. I do feel that in this case investors seem to hold the higher ground and can leverage their options to move their stocks to another company where higher dividends are being paid.

One way of dealing with this is for companies to offer a steady dividend return, that way they can attract the right ‘clientele’ to their company. In order for this to work however the dividend policy needs to remain constant, changes would drive the clientele away to companies that were better able to fulfil their needs, and destroy shareholder value. This lack of fluctuation with the dividend level would reduce the problem of communicating with shareholders and give clarification to shareholders that the company was progressing rather than sending them into a fear of uncertainty.

However the view presented by Miller and Modigliani (1961), suggested that the value of the company was created and secured through investment decisions and not dividend decisions. Therefore rationally shareholders wouldn’t care if their return on investment was made through capital gains or dividends and rejects the ‘bird in the hand’ argument that dividends offer certainty rather than uncertainty of capital gains.

What is clear is there doesn’t seem to be a right or wrong dividend policy. It seems to be a very situational opinion and one that is very dependent on each individual company and the needs and expectations of shareholders. I do believe a constant level seems to offer a sense of certainty but we do not live in certain times and companies don’t operate in certain markets, therefore I think fluctuations are both unavoidable and part and parcel of the securing investor finance and investing in future long-term opportunities.