Clientele Effect

According to this theory, changes in organizational policies affect stock prices.

What would you do if you were a young, risk-hungry investor looking for returns that matched your risk profile? First, you would look at companies that use earnings to finance growth-oriented projects.

Clientele Effect

If that company suddenly decided to set aside a significant part of its earnings to pay dividends, you would likely divest your holdings and look for ventures that promise long-term growth.

The basic premise of the clientele effect is that certain classes of investors favor businesses that adopt specific policies. For example, these policies could concern dividends, taxes, investments, or the enterprise's ESG framework.

If the management alters such policies, the shareholders would likely sell their stake in the organization. 

The clientele effect is a theory that attempts to explain the correlation between share price movements and investor sentiment. Not all investors view a company the same way.

Ratio

For example, an investor whose retirement years appear to be on the horizon would want to generate a stable, periodic income and would thus be interested in dividend-paying stocks

According to this theory, changes in organizational policies affect stock prices. Therefore, investors who previously relied on existing circumstances to fulfill their investment objectives would consider these changes unfavorable.

As a result, investors with similar goals and risk perceptions would then restructure their portfolios, leading to price fluctuations in the market.

To avoid volatility in their stock prices, companies must conform to a set of policies and refrain from making changes to these policies unless necessary.

Impact of organizational policies on investor behavior

By now, you know that different classes of investors have varying investment considerations. Some of these factors are company specific, while others deal with macro-level economic elements, such as inflation.

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Certain theories, such as those proposed by Walter and Gordon, completely disregard the clientele effect.

The theories proposed by Walter and Gordon study the impact of organizational policies on firm value by comparing the investor's required rate of return with the organization's return on investments.

The relevance and consequences of the clientele effect can be better understood by comparing certain theories and their premises with those of the effect.

Furthermore, analyzing certain factors that come into play while purchasing shares of an enterprise will better help understand the clientele effect. Finally, various theories seek to explain the impact of specific company policies on investors' portfolios.

Let us look at two of these theories in detail to better understand investor behavior.

The dividend irrelevance theory - Modigliani and Miller's (MM) hypothesis

Exit

Investors generally want periodic dividends and capital appreciation. However, some prefer one over the other. We can group them into two categories:

  • Young, risk-hungry investors who prefer low dividend payouts and high capital appreciation
  • Retired or aging investors who prefer periodic income and want regular dividends.

The clientele effect assumes that a change in dividend policy would make the business a lucrative investment for one class of investors and an undesirable one for the other. However, Modigliani and Miller came up with a completely different hypothesis.

The MM hypothesis suggests that dividend decisions are irrelevant and do not affect the value of a business.

Idea

The MM hypothesis makes certain assumptions.

  1. The business operates in a perfect market. 
  2. All the investors have the same information.
  3. Taxes are non-existent, or the tax imposed on capital appreciation income and dividend income is the same.
  4. Investors would not incur transaction costs when buying and selling shares.
  5. Every firm has a particular investment policy. This policy will remain unchanged.
  6. Each investor can accurately predict future profits and dividends.

We will explore the implications of these assumptions later. Let us first understand the reasoning behind the MM theory.

The crux of the argument

According to Modigliani and Miller, the value of a business is determined not by dividend payments but by how well the company can generate revenues and fund growth opportunities.

Coins

The MM hypothesis states that dividend decisions are secondary and that the business distributes dividends only after all earning prospects have been exhausted. The MM theory works on account of the arbitrage argument

Suppose a firm wishes to finance a new investment venture. In that case, it has two options:

  • Refrain from paying dividends to the shareholders and use that money to finance the venture
  • Pay dividends to shareholders and finance the project through a public issue.

The essence of Modigliani and Miller's views is that the company's total value will remain unaffected by its dividend policy. This is because of the principle of arbitrage.

In short, arbitrage is the practice of engaging in two dealings, both of which neutralize the effect of the other. The issue of new shares counters the impact of paying dividends to its shareholders.

Chess

Let's break this down, shall we?

  1. A company declares a dividend of $1 per share on June 1st. Its share price is $100.
  2. Any shareholder holding shares on June 7th will be eligible to receive such dividends. This date is known as the record date.
  3. However, there seems to be a catch! You must buy the shares before June 6th to be eligible to receive a dividend. This date is known as the ex-dividend date.
  4. The share price is adjusted for the dividend payment on the ex-dividend date. The new price will be $100 - $1 = $99.

Why does this happen? Simple. The $1 paid out by the company now belongs to the shareholder and cannot be used to account for the company's value. As a result, the company's value is not $100 but $99.

As you can see, what the investor gains because of dividend payment is exactly neutralized by a dip in the share price. This phenomenon is the essence of arbitrage.

A numerical example of the MM hypothesis

How does the payment or non-payment of dividends affect the firm's value? We can better understand this by working out a numerical example.

Numerical

According to the MM theory, discounting the expected dividend and expected share price can determine the current share price of a firm. The discount rate used would be the investor's expected rate of return.

Formula

Where P0 = The current share price

P1 = The expected future share price

D1 = The expected future dividend per share

Ke = The investor's expected rate of return

MonkeyArmy Ltd. currently trades at $100 per share in the market and has 10,000 outstanding shares. Its board of directors wants to declare a $10 dividend per share at the end of the year. The investor's expected rate of return is 12%.

Po = $100

D1 = $10

Ke = 12%

Case 1 - The company pays dividends.

Formula

From this, we know that:

Formula

The expected future share price is $102.

Case 2 - The company does not pay dividends.

FormulaFormula

The expected future share price is $112.

Now, let's value the firm. The firm's profit for the current financial period is $500,000. The firm wishes to finance a new venture that would cost them $1 million.

(All amounts are in $)

Example
 DividendNo dividend
Profit500,000500,000
Less: Dividend paid100,000-
Profit available for financing the venture400,000500,000
Cost of the venture1,000,0001,000,000
Profit available for funding the venture400,000500,000
Amount to be raised through issuing shares600,000500,000
Expected future price of shares102112
Number of shares to be issued5,882 shares4,464 shares
Existing number of shares10,000 shares10,000 shares
Total outstanding shares15,882 shares14,464 shares
Value of the firm = Price per share * No. Of shares (rounded off)1,620,0001,620,000

As you can see, the firm's value is unaffected by its dividend policy.

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Criticisms against the MM theory

The theory proposed by Modigliani and Miller is not without its faults.

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Let us now review some of the underlying assumptions of the MM hypothesis. The primary objections to the theory stem from the validity of the assumptions made by Modigliani and Miller.

1. The MM approach assumes that no taxes come into play. In short, shareholders are indifferent to dividends or capital appreciation, as the tax treatment for both is the same. 

In reality, the differences in taxation of dividends and capital gains may make either one undesirable for the investor, depending on their tax bracket.

2. The theory assumes that there are no transaction costs. This presumption is unrealistic. What is the effect of transaction costs, and how can we trace this back to the clientele effect?

Assume that MonkeyArmy Ltd. is worth $10 per share. Investor A holds ten shares and would get $100 if he sells such shares. With a change in the dividend policy, he will no longer be eligible to receive dividend income.

Therefore, investor A decides to sell his stake in the company. However, due to transaction costs of $5, he will only get $95, which translates to $9.5 per share. How inconvenient!

3. "Investors can accurately predict future profits," says the theory. But, uncertainty is always involved unless the entity in concern is an institutional investor with the resources to predict market trends accurately.

In such a case, investors will prefer immediate income over a greater possible income in the distant future.

4. Not all investors have the same information. For example, it would be absurd to assume that a college graduate who wants to start investing has the same volume and quality of information as an investment management enterprise like BlackRock

Whew! That was a lot of information about dividends. So, to sum up, both the clientele effect and the MM theory attempt to study investor behavior through different spectrums.

Summary
Clientele effectModigliani and Miller
Organizational policy changes affect a firm's value, prompting existing shareholders to sell their investments.The firm's value is affected not by its policies but by its ability to generate revenue and translate such income into growth.

Signaling theory

The clientele effect is all about information and how every piece of information in investors' hands contributes to market fluctuations.

Think about it. The stock market functions because different classes of investors have varying investment objectives and interpret information differently. Therefore, if one set of individuals is willing to buy, another is ready to sell. This discrepancy is called information asymmetry.

If information were symmetric, the market would simply not function!

Meeting

To better understand the signaling theory, let us take an example. MonkeyArmy Ltd. wants to invest in a new project. Broadly, the firm has the following options -

  • Issue equity or preference shares
  • Issue debt in the form of bonds or debentures
  • Finance the project from its reserves.

For this example, let us focus on equity and debt. You are a shareholder in MonkeyArmy Ltd., with a 10% stake in the company, whose value is $10 million. The company decides to issue 10,000 shares to finance this new project.

Because of this issue, you will no longer have a 10% stake in the company but something less than that (say 8%). The implication is that you will have a lesser share of the profits than if the firm had issued debt.

The issue of equity over debt goes against the basic principle of financial management, i.e., wealth maximization.

The signaling theory holds that the market considers a debt issue a positive signal. Upon announcement of the new project, the share prices begin to rise, but the firm refrains from issuing equity, as it believes its shares are underpriced.

Room

If the firm goes for an equity issue, its share prices will decline, as the market considers an equity issue a negative signal. Even an enterprise with bright potential will experience a dip in its share price if it opts for an equity issue.

We can look at the signaling theory from another angle. If the firm expects one of its products to become obsolete shortly and must invest in technology to keep up its existing sales, it would have to go for an equity issue.

In a negative-net-profit scenario, spreading such loss among more shareholders is still consistent with the theory of wealth maximization. 

Key Takeaways

  • The clientele effect examines the effect of a change in business policies on share prices.
  • The theory holds that market fluctuations are primarily due to the clientele's perception of organizational policies.
  • Since this theory is primarily concerned with studying price movements and investor behavior, we looked at other ideas that learned the impact of shareholder perceptions.
  • The Modigliani and Miller hypothesis studied a firm's dividend policy and concluded that such policies do not affect the firm's value. Instead, the business's earnings and growth potential do so.
  • The signaling theory studied the effect of a change in the organization's capital structure on its share prices.
  • According to the signaling theory, an equity issue is usually regarded as a negative signal and hurts share prices, while a debt issue has a positive effect.
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Researched and authored by Sathyanarayana Sairam | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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