Why dividends Matter
Or why the dividend irrelevancy theory is wrong
This is a very popular and commonly discussed theory, but unfortunately not one that is true.
Let’s talk about that.
What is the Dividend Irrelevancy Theory?
What better than Investopedia to explain it?
The dividend irrelevance theory holds that the markets perform efficiently so that any dividend payout will lead to a decline in the stock price by the amount of the dividend.
As a result, holding the stock for the dividend achieves no gain since the stock price adjusts lower for the same amount of the payout.
In other words, a company paying dividends or not should have no effect on the stock price.
If this sounds stupid to you, that’s because it is.
That said, there are a few assumptions that Modigliani and Miller outlined in 1961 that are assumed in this theory:
The capital markets are perfectly efficient
There are neither flotation nor transaction costs
There are no taxes
The capital structure does not affect cost of capital
Management and investors have equal and full timely access to all public and private information and there are no arbitrage opportunities
The cost of equity is constant at any dividend payout rate
The dividend policy does not affect capital budgeting
In addition to this, it is also often claimed that Investors cash flow is unrelated to a companies dividend policy, since they could simply sell a suitable amount of shares, in order to replicate the dividend yield they would otherwise receive from the company.
Why It’s Wrong
The first reason why the theory just doesn’t work is easy enough to understand, after all, none of the theories assumptions are in any way realistic.
Markets are not perfectly efficient, they are only stochastically so, and that’s proven by the fact that arbitrage is an investment strategy that not only exists, but is highly profitable.
Transaction costs have been reduced in the recent past with low cost brokers, but they do still exist.
Taxes are as certain as death.
Highly indebted companies generally have a harder time getting favorable interest rates.
Information is fragmented and decentralized, and although hedge funds spend huge amounts of money on research, not everyone can have that much information, and even that has its limits.
The cost of equity too changes based on the payout ratio, and the dividend policy changes and constrains the companies capital budgeting.
What’s actually happening
That being said, there does seem to be a noticeable drop on the Ex-Dividend date.
We can see this happening on Altria ($MO) which recently had a dividend go Ex-Dividend:
So what’s happening here?
Well, it actually has a very simple reason, people (and investment firms) are running dividend harvesting strategies on Altria.
Dividend Harvesting is a strategy that some people conduct in order to take advantage of a company issuing dividends. The way it works is simple to understand, and essentially follows the following steps:
Company announces a dividend
Investor purchases the stock prior to the Ex-Dividend date
The Ex-Dividend date arrives and the investor will now receive the dividend
Investor sells the share
Essentially, the investor is only looking to receive the dividend, and does not intend to hold the shares continuously to the long term. They may perform this strategy with many companies, allowing them to continuously receive dividends.
Of course this buying and selling of the stock has effects on the stock price, upon announcement of the dividend and the payment of it. after all, people running this strategy will increase the demand for the stock prior to the Ex Dividend date, and increase the supply after the date, as they divest themselves from the stock.
The way this works is simple, when the dividend is announced (or prior to that, when it becomes expected that it will be announced) the company will have its valuation adjusted by the discounted value of the dividend.
This essentially results in the dividend value being progressively added to the share price until the ex-dividend data, at which point it will be removed because the dividend has been paid.
Of course there are other factors that influence the share price, but we can expect the announcement of the dividend to provide some upward pressure on the shares.
So, did this happen with Altria?
We can see an increase in price immediately after the announcement, as a result of the new information causing investors to purchase shares to harvest the dividend, and the decrease as the Ex-Dividend date passes, due to those investors selling the shares now that the reason they bought them for is no longer relevant.
In short, the Dividend Irrelevancy Theory is a common misconception, that appears to be accurate as a result of the actions of investors performing certain types of investment strategies.
Ultimately though the assumptions of the theory are unrealistic, and the behavior observed is better explained by other factors.
Have I convinced you? Do you still think the Dividend Irrelevancy theory is true?
Let me know what you think!
And as always, if you have any questions or comments, shoot them on Twitter @TiagoDias_VC or down below!
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