Dividend Irrelevance Theory

What is the Dividend Irrelevance Theory?

According to the dividend irrelevance theory, dividends have no impact on a company's stock price. Typically, it is a cash payment from a company's profits to its shareholders as a thank-you for their investment.

According to the dividend irrelevance hypothesis, paying out profit to shareholders might reduce a company's ability to compete over the long run because it would be wiser to reinvest this money to increase profitability.

Many detractors of its irrelevance argument contend that it assists a company's stock price increase, even though some businesses have chosen to pay profit to shareholders rather than increase their earnings.

According to the Theory, a company's prospective profitability or stock price is not increased by paying out profit to shareholders. Therefore, it implies that having stock in firms that pay dividends is not preferable to stock in companies that do not.

According to the argument, a company's decision to declare and pay profit to shareholders should have little to no effect on its stock price. If this hypothesis is accurate, dividends do not raise a company's stock price.

According to the theory's underlying tenet, a company's market value is determined by its capacity to turn a profit and expand its clientele rather than profit payments to shareholders.

The theory proponents contend that profit to shareholders doesn't provide additional benefits to investors. On the contrary, in some situations, payments may even be detrimental to the company's financial health.

Stock Price and Company Profitability

According to the dividend irrelevance argument, if markets operate effectively, each payment distribution will cause a corresponding fall in stock price.

To put it another way, if the stock price was $10 and the company paid a $1 dividend a few days later, the stock would decline to $9 per share. Because the stock price drops for the same amount of the payment distribution, owning the shares for the distribution results in no profit.

However, research indicates that when the book closing date draws near, the price of stocks that pay profit to shareholders, such as many well-known corporations known as blue-chip stocks, frequently increases by the payout amount.

Even if the price may fall after the dividend has been paid, many investors who desire profit for shareholders should be maintained by these companies because of the reliable payouts they provide, which fosters an underpinning level of demand.

Additionally, a company's stock price is influenced by factors other than its dividend payout schedule. Analysts determine the intrinsic value of a stock through valuation exercises.

These frequently include qualitative criteria like managerial caliber, economic factors, and an awareness of the company's position in the industry, in addition to quantitative measurements like financial performance and qualitative measurements like dividend payments.

Stock prices reflect how lucrative investors anticipate a company will be by demonstrating how they purchase shares of a company in the hopes of making a profit.

Many internal and external factors affect a company’s stock price. They consist of the following:

• Management has changed
• Worker layoffs
• New rules from the government
• Worldwide pandemics
• Monetary patterns
• Public relations and consumer perceptions of the business.

Some investors think that paying a profit to shareholders raises the value of a company's stock. The theory contends that this is untrue, nevertheless.

Dividends and Their Relationship with Profitability

Stock price increases are capital gains, while dividends provide consistent income for your portfolio. Therefore, understanding the connection between business earnings and dividend policy is necessary for strategic investing.

Corporations use their operating profits to pay profit to shareholders. Therefore, a company is likely to increase the payments with increasing profits.

1. Dividends do not raise the stock price; they are a cost to the corporation

They are conceptually irrelevant to a company's value because paying them does not improve its profit-making capacity.

A corporation can reinvest more money into itself when it makes a profit. Investors may interpret this as a hint that the company now has more resources available to generate more profits, which could raise the value of the company's stock.

However, if the corporation pays profit to shareholders, it diverts funds from self-investment into the hands of shareholders and forfeits some of its profit potential.

Therefore, it is implied that paying profit to shareholders has a "cost" for the corporation.

2. Equivalence of dividend issuance and non-issuance

According to logic, the amount of profit paid out to shareholders equals the loss of potential income caused by dividend issuance. As a result, the company's share price will then drop by the amount of the dividend paid.

The profit distribution to shareholders has no impact on an investor's wealth.

If the firm in which we hold shares pays profit to shareholders, our available cash increases by the dividend's amount, but the stocks we own now have a lower value due to the profit to shareholders paid; therefore, there is no net gain.

Company's Financial Health and Dividends

According to the theory, companies' financial health may be harmed by giving profit to shareholders, which is not unheard of.

1. Taking Debt

Paying profit to shareholders could affect a firm if it takes on debt by issuing bonds to investors or borrowing from a bank's credit facility to meet its cash dividend payments.

Let's imagine a business has considerable debt on its balance sheet due to previous acquisitions. It may be harmful to pay interest or debt servicing fees. Additionally, having a lot of debt can make it difficult for businesses to get more credit when needed.

The dividend irrelevance theory's proponents contend that the corporation is hurting itself if it takes a hard line and always pays profit to shareholders. Those dividend payments over several years may have been used to reduce debt.

If the company has less debt, it may be able to negotiate better terms for the remaining debt, which would lower the cost of the debt payment.

Additionally, debt and dividend obligations can restrict the business from making an acquisition that might assist boost long-term earnings. So, it can be challenging to determine whether profits for shareholder payments are to blame for a company's poor performance.

A company's problems may be exacerbated by inadequate debt management, ineffective management, and external variables like weak economic growth.

However, companies that don't pay profit to shareholders have more cash on hand, which they can use to make acquisitions, invest in assets, and reduce debt.

2. Spending on CAPEX

A company's valuation may decrease if it does not make capital investments (CAPEX) in its enterprise as earnings and competitiveness deteriorate over time.

Large investments made by businesses in their long-term financial stability are known as capital expenditures, which might include the purchase of land, structures, machinery, and other assets.

Investors who purchase dividend-paying companies must assess a management team's ability to balance dividend payments with future investments.

Dividend Irrelevance Theory and Portfolio Techniques

Many investors prioritize paying profit to shareholders while managing their portfolios, notwithstanding the dividend irrelevance theory. For instance, a current income strategy looks for investments that pay higher than average distributions (i.e., profit to shareholders and interest payments).

Current income techniques can be used in various allocation decisions across a gradient of risk even though they are generally risk-averse.

Income-focused strategies are typically suitable for retirees or risk-averse investors. These income-seeking investors purchase shares of well-known companies with a history of reliably paying profit to shareholders and little chance of missing a dividend payment.

Blue-chip businesses typically pay consistent profit to shareholders. These are large, established international corporations like Coca-Cola, Disney, PepsiCo, Walmart, and McDonald's.

These businesses have developed famous brands and are undisputed leaders in their respective industries, having weathered numerous economic downturns.

These can also be beneficial for portfolio strategies that focus on capital preservation. For example, the profits from dividends can assist in balancing losses if a portfolio loses money due to a fall in the stock market, protecting an investor's hard-earned resources.

The systematic procedures known as portfolio management (PM) approaches are used to analyze or evaluate a group of projects or activities to strike the ideal balance between stability and growth, risks and returns, and benefits and downsides.

It focuses on achieving this equilibrium by making the best use of the scarce resources at hand.

Examining the Dividend Irrelevance Theory

The irrelevant theory is the subject of today. The Modigliani-Miller dividend irrelevance theory is another name for it. It is also known as the MM theory.

It is wise to consider the opposite viewpoint to see what might be discovered and how to use it to invest profitably.

Finally, I'll discuss three companies with you, along with their stock prices, before we finish.

I'll also demonstrate how to increase $1,500 to more than $5,000 using a dividend-irrelevant approach. Let's do it, then.

The first tenet of this theory is that investors don't care how their returns are generated.

What counts is the entire investment return. It comes from profit to shareholders, share price growth, or a combination of the two.

It also suggests that a company's dividend has no real value. The profit payout policy is also unimportant because it does not affect the company's worth or the price of its stock.

It contends that profit to shareholders may be detrimental to a corporation.

Since management can and ought to spend the money in more productive ways.

One of the three theories is the irrelevance of the dividend. And whether you admit it or not, you favor one of these three hypotheses.

If not, you should start to harbor a bias. Also, be aware of it. Why?

Because the dividend hypothesis will partially determine the investment approach you subscribe to. Additionally, every investor needs to create an investing plan.

An investment strategy is, to put it simply, a planned course of action. It influences the decisions you make as an investor.

In general, dividend theories are significant for this reason. And more precisely, why it's crucial to comprehend the irrelevance theory.

Bird In Hand Dividend Theory

John Lintner and Myron Gordon developed this hypothesis. However, the dividend irrelevance theory, developed by Modigliani and Miller, is opposed to this idea.

According to Modigliani and Miller's theory, a company's dividend policy has no bearing on its worth or capital structure. That argument also suggested that investors would not differentiate between dividend or capital gain returns because they would only look at the overall returns.

Bird-in-hand theory, in contrast to the irrelevance of dividend theory, is predicated on the idea that investors place a high value on getting profit to shareholders. It's sometimes referred to as dividend relevance theory.

Furthermore, a bird in the hand is based on an old phrase. As the saying goes, a bird in the hand is worth two in the bush.

The adage implies that it is preferable to hang onto things that you either already have or can anticipate getting shortly. Compared to the chance of losing whatever "it" is by attempting to obtain something greater and better in the future.

What does this have to do with dividends? Well, it's fairly easy.

You may rely on receiving payments from high-quality equities that offer profit to shareholders. The bird in your palm is it.

As opposed to the potential for significant rises in a stock's share price. That might or might not happen later.

The two birds in the bush are increasing in share prices. Or something that might be in the future superior to payouts now.

The contrast between dividend relevance and irrelevance theory is now complete.

Tax Preference

The tax preference theory, also known as the tax aversion hypothesis, is the third dividend theory.

While the "bird in hand" theory directly contradicts the "dividend irrelevance" viewpoint. It is more comparable to the tax preference hypothesis.

The foundation of tax preference theory is the notion that an investor's top priority is reducing taxes. Therefore, they also consider them when making investing selections.

As a result, investors who adhere to this notion strongly favor stock price growth. Capital gains result from this. Additionally, they prefer not to collect profit from shareholders.

Historically, capital gains were taxed more heavily than profit to shareholders. And when received, profits for shareholders are taxed. While an investor only pays taxes on capital gains if and when they decide to sell their stock.

It makes sense to give tax preferences. Taxing at a lower rate or postponing tax payments as long as feasible is always preferable.

However, you can restrict this tax problem by adding dividend-paying equities to an Individual Retirement Account (IRA).

Who Are Modigliani And Miller?

Two economists, Franco Modigliani and Merton Miller created the dividend irrelevance theory.

Mr. Modigliani was an economist who was of Italian descent and American.

He was awarded the Economics Nobel Memorial Prize in 1985. He taught at the MIT Sloan School of Management, Carnegie Mellon University, and the University of Illinois at Urbana-Champaign.

Mr. Miller was an American economist, according to Wikipedia.

He studied for most of his academic life at the Booth School of Business at the University of Chicago. They shared the 1990 Nobel Memorial Prize in Economic Sciences.

Some of the assumptions are:

As you can see, academics established the theory of dividend irrelevance by economics academics.

The company and the environment in which it works are relevant to the theory's assumptions. As follows:

1. There is no flaw in the capital markets.
2. Neither flotation charges nor transaction costs exist.
3. Taxes are nonexistent.
4. The cost is unaffected by the capital structure. In other words, regardless of the ratio of debt to equity, the cost of capital stays constant.
5. Investors and corporate management have equal access to all public and private information.
6. None of the payment distribution rate, the cost of equity remains constant.
7. The capital planning process is unaffected by the dividend policy.

Dividend Irrelevance Theories and Policy

First, this is a framework for thinking about and describing a situation.

Payout theory also serves as the foundation for a company's payout policy. But, at the same time, the actual business action that affects whether or not dividends are paid to people like you and me is the dividend policy.

There is a policy in place at corporations that adhere to the dividend irrelevance theorem. But it's quite easy. They decide not to pay a dividend under their policy.

Or, to put it another way, dividend policy is irrelevant because they believe they can put their money to better use by adhering to dividend irrelevance uses that will significantly increase the company's worth and stock price instead of paying profit to shareholders.

So, how exactly should a business use its cash?

If a corporation has cash, its payout policy is irrelevant. They also decide not to distribute a dividend. Therefore, they need to take action with this important resource.

What are they doing with their money, then? Companies may choose to spend their funds in the following ways:

1. Invest again in the company
2. Acquire additional companies
3. Remit debt
4. Repurchase their stock on the market
5. Choose not to use any of their available funds.

Let it build up for liquidity needs, following the irrelevance of the dividend principle.

Management states that one or more of the possibilities mentioned above is a better use of capital by implementing a no-payment dividend policy.

Dividend Irrelevance Theory Criticisms

Let's take a look at some of the criticisms of the theory below.

1. There are many excellent reasons why businesses pay profits to shareholders. Some investors, including myself and exchange-traded funds, look for businesses that generate dividends and will only purchase dividend-paying stocks.
2. Business managers could be prone to "empire building" if they have enough money at their disposal. Or perhaps they made poor decisions about where and how to spend their money.
3. Dividend irrelevance requires investors to sell and decrease their ownership position to get cash.
4. Recurring dividends might also build management discipline when they know that a portion of their wealth needs is set aside for dividends. With the money left over, they must exercise good judgment.
5. Only some businesses will succeed in the same way as Alphabet, Facebook, and Amazon. I can identify a corporation that did not include dividend payments in its policy for each of these businesses. They did not make prudent investments or innovations, thereby damaging shareholder value.

Numerical Example

Here are a few stocks that would be appropriate for an investment plan based on the theory.

Example 1: Alphabet, Inc.

Alphabet is the parent firm of the world's largest internet search engine, Google. It was established in 2015 as a result of Google's restructuring.

Alphabet Inc. was founded to narrow the focus of Google's main internet search business while permitting the aggregation of enterprises engaged in industries other than internet services.

• Nasdaq ticker: GOOGLE as of December 31, 2015. 
• Price per share: $778.01 
• Price per share: $1,752.64 as of 12/31/2020
• Return on investment annually: 17.63%

Example 2: Facebook, Inc.

A technology company, Facebook provides more goods and services in addition to its well-known social networking site, including WhatsApp, Instagram, and Facebook Messenger.

• Nasdaq stock ticker: FB
• 12/31/2015 Share price: $104.66
• Price per share as of 12/31/2020: $273.16
• Return on investment annually: 21.15 percent

Example 3: Amazon, Inc.

Amazon has grown significantly since its humble beginnings as a dormant internet bookseller in 1994. E-commerce, cloud computing, digital streaming, and artificial intelligence are now within their business reach.

• Nasdaq stock ticker: AMZN
• 12/31/2015 Share price: $675.89
• Price per share as of 12/31/2020: $3,256.93
• 36.96% annual return on investment

Conclusion

The relevance and irrelevance hypothesis of dividends will now be summarized.

The MM theory is one of three well-known theories to start with.

This strategy was developed based on the idea that investors don't care how they get their investment returns. Additionally, businesses believe they can put their money to better use instead of distributing profits to shareholders.

Furthermore, these theories offer to guide ideas for creating distinct business dividend policies. These regulations may or may not result in dividend investors like you and me receiving cash dividends.

For businesses that think their policies are irrelevant. They don't pay dividends; that is their dividend policy.

Whether you realize it or not, you are biased in favor of one of the dividend theories as an investor. Additionally, it influences some of your investment choices.

Last, we considered instances like Alphabet, Facebook, and Amazon and observed that shares of corporations whose policies are perceived as irrelevant by investors generate significant profit.

Researched and authored by Deeksha Pachauri | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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