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Bird-In-Hand And Dividend Irrelevance Theories
In the Spotlight | 16 April 2015
By: Alvin.Chow
Articles (5) Profile

“A bird-in-hand is worth two in the bush” – anonymous

This is how dividend investors see the market. Having a cash payout appears to be better than the company retaining the earnings for growing the business. The latter is full of uncertainty as the company may eventually collapse with the investors ending up with nothing. Hence, it seems to be better to get the money out first!

It was Myron Gordon and John Lintner who came out with this bird-in-hand theory. It proposed that investors prefer dividends to capital gains. Capital gains are more risky and investors expect to be compensated by higher returns, putting pressure on the management to deliver higher growth in the future, which may or may not happen.

To the firm, the cost of holding the retained earnings is actually higher than distributing it away. With higher cost of capital, the company is less competitive to a similar competitor which issues dividends (think return on capital).

Hence, the duo believes that dividend returns and the future growth rate of the dividends are the total returns to the investors. If true, the value of a stock can be determined by the Gordon Growth Model.

Below is the equation that sums up the Gordon model:

The dividend effect has been studied by academia but researchers could not reach an agreement with one another.

Dividend Irrelevance
On the other hand, Franco Modigliani and Merton Miller proposed the dividend irrelevance theory, which states that a company’s dividend policy has no impact on its cost of capital or on shareholder wealth.

Imagine a firm gives out all its earnings as dividends. Under such scenario, to finance a new project, the company is likely to issue new shares to raise money from the shareholders, and that would offset the value of the dividend issued.

This is exactly what we see with real estate investment trusts (REITs). Having to pay out 90 percent of the earnings to investors, and a cap on borrowing limits (gearing limits – unrated REITs: 35 percent, rated REITs: 60 percent), some REITs may find it challenging to find funding to expand their property portfolio.

The usual approach is to issue rights from time to time, clawing back money from the dividends they have distributed. Teh Hooi Ling, an ex-Business Times journalist, wrote an article about this a few years back and showed majority of the REITs have issued new units at some point in time.

There are many other theories revolving dividends. Another theory is that a firm’s management can use the issuance of dividends as a form of signalling. For example, if the company is suspected to face solvency issue, the management may distribute dividends as a show of financial strength within the company.

How I See It
Personally, I agree with Modigliani and Miller that there is no change in shareholder’s wealth regardless the company distribute the dividends or not.

But in reality, I find that people generally have preference for dividends over capital gains. And that preference can translate to higher demand for dividend paying stocks, and further translate to premium prices for these stocks. Jon talked about this behavioural inclination in this article. In this sense, I would agree that Gordon and Lintner are also right on the inclination for dividends.

That said, I am speaking on the basis of observations made in Singapore, where dividends are not taxed. In other countries, the dividend tax may be significantly higher than the capital gain tax, and that may result in more people investing for capital gains.

Ultimately, I just want to know the market consensus. In this case, I am concerned about the degree of valuation asymmetries between dividend-paying companies and companies that do not. I believe it is the collective preference in the stock market that tells us what to avoid since contrarians (some but not all) usually make the money.

If I can establish that the majority of the market participants invest for dividends, which results in premium stock prices for dividend-paying companies, I would likely avoid them.

Alvin Chow is the founder and director of BigFatPurse Pte Ltd and believes financial literacy is crucial to the well being of Singaporeans as our standard of living continue to rise.

Please click here for more information about this author.


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