Dividend policy is at the forefront of some stock pricing models (The Gordon Model). Basically the models are discounted cash flow formulas that use the expected dividend growth rates along with some other variables to determine valuations for stocks. A key element to the theory is that investors buy stocks with the hope that the firm will eventually pay dividends. If a company is not paying dividends the models will substitute the EPS growth rate, assuming that earnings will eventually translate into dividends. Of course this is only theory and may make some sense on a certain level. But a theory only works if the mass of investors use it. I highly doubt most investors use this model. I prefer a simple P/E to growth analysis as I feel most investors also do. If I would have adhered to the Gordon model I would have not bought many stocks that have done well for me. Please refer to the following link for more information on the Gordon Model: http://en.wikipedia.org/wiki/Gordon_model (As you will see the formula is a little intimidating and has many questionable assumptions)
Instead of using dividends as a way to establish a valuation for a stock I prefer to use the overall dividend policy of a firm to get insights into the future of the company and its opportunities.
Example One: Company pays a special dividend.
A special dividend is when a firm declares a dividend in addition to its normal dividend or declares a one time dividend when it is not paying any dividends. For example, this can occur if the firm sold some of its assets and as a result may receive a pile of unexpected cash. Alternatively, it can also occur if the firm is doing so well that its cash flow is vey healthy and it wants to reward its investors. Of these two situations I prefer the second since it conveys that the firm is doing well since the cash it received is from normal operations and not from a one time asset sale. It could lead to a higher stock price as investor expectations rise. There is one caveat. In general, investors may prefer a company not to pay out the dividend, but would rather have the firm reinvest the cash to grow the business. No reinvestments could mean that the company sees no opportunities. Keep in mind that when no opportunities are present the investors would rather receive dividends, but it is likely that the stock price may still have a low relative valuation.
Example Two: Management is increasing quarterly dividend.
- Example Company One: The firm is increasing its dividend by 10%. Also its earnings are growing quickly.
- Example Company Two: The firm is increasing its dividend by 30%. Also its earnings are growing quickly.
*Assume that both firms are of the same size and growing at the same rate.
In this example, Company One is paying less dividends and reinvesting more of its earnings relative to Company Two. This could result in a higher relative valuation as investors may see Company One as having more growth opportunities.
Example Three: Company cuts its dividend
This situation is often perceived as negative, inferring that the company has cash flow problems. However, if the company is about to enter a period of new growth, cutting the dividend and reinvesting for new growth may lead to higher valuations in the long run. Also if, due to cash flow problems, the company is cutting the dividend as an overall restructuring policy then investors may see this is a positve.
There are many more examples, but the main point is that to maximize shareholder value a firm should make certain that its dividend policy is in line with its growth opportunities. If there are many opportunities, then less dividends should be paid. If the opportunities are scarce, then a more aggressive policy may be warranted. I am of the opinion that investors will place a higher valuation for stocks that pay less dividends as it implies that growth opportunities exist.
Risk Analysis
Tracking 1027 U.S. listed China Stocks and Counting...
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