Appendix 4 - Dividend Irrelevance

In this week’s blog I am going to cover dividend policy’s, which will include another theory from Modigliani & Miller. Once again, their theory assumed everything was perfect, there was no tax and the markets were efficient. M&M’s theory was titled Dividend Irrelevance; however do not be fooled by this because they do not argue that dividends themselves are irrelevant.

M&M do not argue that whether or not dividends are paid is irrelevant to the company’s valuation; if dividends are never paid then the shares in a company will be completely worthless. They argued that shareholders are indifferent, because if a company does not pay a dividend, and chooses to invest in +ve NPV projects, then the share price will rise and therefore the shareholder can create their own dividend by selling some shares. On the other hand, if a company does pay dividends then the shareholders can use that payment to buy more shares. M&M’s key point in this theory is that +ve NPV projects should always be undertaken, which is something I completely agree with.

Put yourself in the shoes of a shareholder, would you rather receive a small dividend today, or instead of paying dividends, the company invested into projects that have a positive rate of return, which in turn will help to increase the company’s value. I know if I had that choice, I would prefer for the funds to be reinvested. The shareholder will benefit from the rising share price of the company and can receive a dividend that way.

Nowadays fewer companies are choosing to invest their profits in the business. Instead they are serving the short term interests of shareholders by paying dividends, according to Andrew Haldane, the chief economist of the Bank of England. He believes this is having a damaging impact on the growth of the economy. It is believed that between 60-70% of profits are now being returned to shareholders, a huge increase from the 1970s where the figure stood at 10%. I found an intriguing article on the FT website on this subject, which can be found here.

Why don’t companies invest 100% of their profits? Surely, it would make sense to do so in order to grow. Well investors sometimes look at dividend payments to see how a company is performing; high dividends are good whilst small dividend payments are bad. As there is no insider information available, investors have to base their decisions on what is publically available. Therefore some companies may believe paying dividends is a way to grow as people are more likely to invest as a result. This is a very short-term view; something which Andrew Haldane believes is damaging the economy.

In another article on the Financial Times, Terry Smith said that if you opt to spend the dividend or you do not invest it then you will not perform as well. The graph shows that it is the rate of return that you make on the reinvestment or dividend, which makes the biggest difference. Company A does not pay any dividends and reinvests 100% of profits, with a 20% rate of return. Company B has the same return but only invests 70% of profits, with remaining 30% used for dividends. Whilst Company C also reinvests all its profit, the rate of return is lower at 10%.

So to conclude, I believe that it is in the best of interests of both the company and the investor that profits are reinvested in order to grow and increase the company’s value. Although dividends may be demanded by some shareholders in the long run they will get more back from investments which will generate wealth.