CONTROVERSY ON THE EFFECT OF DIVIDEND PAYMENT ON THE VALUE OF A FIRM OR A STOCK|By Idika Aja|1st published by National Business Extra

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There are a lot of variations on how dividends are paid out by different companies.  For instance, some pay dividends in cash, some issue stock dividend/split. Stock dividend is much like stock splits, but the distinction between the two is technical. Stock dividend is just shown as transfer from retained earnings to equity capital, whereas stock split is shown as a reduction in the par of each share.  Both of them increase the number of shares, but the firm’s assets, profit, and the total value are unaffected. Some vary the dividend to be paid; lower or increase it depending on the recent profit made.

SAHCO2However, not all listed firms pay dividends.  For instance, about 95 firms listed on the Nigeria Stock Exchange declared dividend in 2019. Those that pay, do so, to show appreciation to their shareholders for their investments and encourage them to invest more. Also, some believe that a firm’s decision to pay dividends is subject to the weighted average of current earnings and past earnings. Thus, according to Lintner’s (1956) simple model, payment of dividend depends in part on the firm’s current earnings and in part on the dividend of the previous year, which in turn depends on that year’s previous earnings and the dividend in the year before. Consequently, dividend payment depends on the weighted average of current earnings and past earnings.  As such, mature companies with stable earnings; pay out high proportion of their earnings, while growth companies have low payout (if they pay dividends at all).  

Also decision to pay a dividend or not is often mixed up with either financing or investment decisions. Some firms pay low dividends or do not pay at all, because management is optimistic about the firm’s future and wishes to retain earnings for expansion. In this case the dividend is a by-product of the firm’s capital budgeting decision.  Another firm might finance capital expenditures largely by borrowing, this releases cash for dividends. In this case the firm’s dividend is a by-product of the borrowing decision.  Albeit to above, different opinions have been posited on whether or not dividend payments or not, increase or decrease/affects stock price and firm’s value:

On the right, known as the conservative, believes that increase in dividend, increases stock price or firm’s value.  They point out that there is a natural clientele effect for high-payout stock. For example, some financial institutions are legally restricted from holding stocks lacking established records.  Trust and Endowment funds may prefer high-dividend stocks because dividend are regarded as spendable “income” whereas capital gains are “additional principal”

dividend theories

On the left, known as radical group believes that increase in dividend payment reduces firm value. They argue that when dividend is taxed more than capital gains, firms should pay the lowest cash-dividend they can get away with, such that, available cash can be retained for future profitable investment or used to repurchase shares. They argued that if dividend attracts more tax than capital gains, why should any firm pay dividend? And if cash can be distributed to stockholders, then share repurchase is always the best channel for doing so. So the leftist called for not only for low payout but for zero payment especially when tax on dividend is heavily higher than tax on capital gains.  Apart from having higher tax on dividends to capital gains, some have argued and posited that it is a double taxation, since some corporations pay tax on their profits in addition to the tax (WHT) on dividend deducted by investee companies before remittance of dividends to the shareholders. For example, in Nigeria, in line with section 80 of the Companies Income Tax Act (CITA), investee companies are required to deduct 10% Withholding Tax (WHT) on declared dividend before remittance to the shareholders. The shareholder is not required to file a tax return, if the dividend is only the source of income. Furthermore, Section 19 of same CITA requires companies to pay CIT of 30% on the amount by which the dividends exceed its taxable profits for the referenced year.  In recognition of this double taxation, and to ameliorate it, some countries, give shareholders at least some credits for the tax the company has already paid. In the same vein, The Finance Bill 2019 before the National Assembly is billed to amend Section 19 of the Nigeria CITA “To amend the excess dividend tax rules that currently results in double taxation and discourages corporate savings/retention of profits; to improve investor confidence and encourage FDI”

At the center, known as Middle-of-the-Roaders represented by Miller, Black and Scholes maintained that a company’s value is not affected by its dividend policy. They published a theoretical paper showing the irrelevance of dividend payment where there is a perfect market of no taxes, transaction costs or other market imperfections.  They equally recognize the possible high payout clientele group, but argue that they are satisfied also. On the argument on higher payout being discouraged by high taxes, the middle-of-the-roaders are of the view that there are plenty of wrinkles in the tax system which the stockholder can use to avoid payment of taxes on dividend. For example instead of investing directly in common stocks, they can do so through pension fund or insurance company which receives more favorable tax treatment.  Therefore, companies that pay low dividend will be more attracted by highly taxed individuals, while those that pay high dividend will have greater proportion of pension funds or other tax-exempt institutions as their stockholders. They argued that investors may not need dividend to get their hands on cash and as such will not be willing to pay higher prices for the shares of firms with high payouts. Therefore firms might not worry about dividend policy, but let dividends fluctuate as a by-product of their investment and financing decisions.  Any increase in cash dividend must be offset by a stock issue, if the firm’s investment and borrowing policies are held constant. In effect the stockholders finance the extra dividend by selling off part of their ownership of the firm. Consequently, the stock price falls by just enough to offset the extra dividend. Also as expected switching from cash dividend to share repurchase has an effect on shareholder’s wealth. When shares are repurchased, the transfer of value is in favor of those who do not sell.

What then is the impact of payment or non-payment of dividend on the value of the stock and the wealth of a company? When you buy stock, there are two income streams expected – dividend and capital gain. The value of a stock is the present value of the dividend and stock price discounted at an appropriate discount rate.  You can use Gordon growth model, two-stage or three-stage dividend discount model to value the stock. When dividend goes down, holding the discount rate constant, the intrinsic value of the stock may drop and as such, the stock may become less attractive to investors. More so, investors may see the declining dividend as the company has fallen on hard times.  The truth could be the company is using its profit on other things such as funding expansion, but the market perception at times is more powerful than the truth. On the other hand, when dividend goes up, the intrinsic value of the stock may increase thus making the stock more attractive to investors.

total plc

In some cases, investors considers rising dividends as a sign of a company’s good health, especially when it is underpinned by rising earnings or the decrease/increase in dividends is commensurate with earnings and meets investors’ expectations. In essence, the dividend payout of a firm has to be consistent with the assumption of stability, since stable firms generally pay substantial dividends.  For instance, in 2017, Total Nigeria Plc recommended a final dividend of N17 per share for the year ended December 31, 2016 to be paid from PAT of N14.769bn recorded in the year, a 265.5% increase from N4.1 billion recorded in 2015 to N14.769 billion recorded in 2016. Based on the result, the market reacted negatively as the shares fell by 5.4 per cent to close lower at N274.55.

Analysts believe that the final dividend recommended by Total Nigeria was below market consensus given the strong earnings growth recorded. This works out to a dividend payout of just 39 per cent, the lowest in over two decades.

Notwithstanding the controversy, the important thing is what you, as an investor wants to achieve; to detect if the stock is under or overvalued and why.   Dividend is not the only factor that affects the value of a stock. Stock price may also react to some other changes such as profit and sales projections.

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