The most common description of the goal of enterprises is the pursuit of maximization of shareholder value. To achieve this a company strives to maximize its overall earnings. If a company has accumulated cash by conducting profitable business, it might decide to let its equity holders participate in the profits. This can for example be done by means of a cash dividend, which is paid out to stockholders as an absolute amount per share.
Let us first have a look at the normal schedule under which companies pay out cash dividends. The initial date of the dividend payment process is the declaration date on which the company publicly announces the next dividend payment. The announcement states the ex-dividend date, the payment date as well as the absolute amount of the payment per stock. At that moment no actual payments have been made and the stock still trades “cum-dividend”, i.e. with dividend. The next significant date is the ex-dividend date. If a stockholder wants to be entitled to receiving the announced dividend, he has to own stock on the day before the ex-dividend date. Everybody who owns stock on the day before the ex-dividend date is therefore automatically eligible for a dividend payment. When stock markets open on the ex-dividend date the stock trades at a lower price (i.e. it trades ex-dividend, so in other words without dividend) because investors who buy the stock from here on out will not receive the payment (more in detail later). The ex-dividend is usually two business days before the record date. The record date is the day on which an investor must be registered as a shareholder to be entitled to a dividend payment. To be a shareholder on the record date one must have bought stock three days before, on the day before the ex-dividend date, i.e. on the last cum-dividend day, since the clearing process of the transaction takes three days1. The last date in the process is the payment date on which the actual payment checks are sent out to the shareholders.
The objective of the course BFIN 457R is to conduct research in the field of financial markets and institutions. This requires looking at the dynamics of financial markets and analyzing what factors affect the institutions in it. This paper will concentrate on the effects of dividend payments. The first main source introduces a general theory of dividend payments by Modigliani and Miller. This is one of the major studies in the field and evaluates the effect of dividend policies on the overall valuation of a company. Sources two and three are more practical and analyze the dividend payment process and its immediate influence on the stock price. They advocate two different approaches to how the payment of a dividend should influence one’s investment in the company paying the dividend.
Companies have to decide on their dividend payment policy. That means the board of directors needs to determine which amount of dividend to pay to their shareholders. The debate whether dividend payments increase the overall valuation of the firm or not has always been a controversial one. The first source I want to introduce is the “Dividend Irrelevance Theorem” by Modigliani and Miller from 1961, as described in the book Fundamentals of Financial Management2. This is one of the most celebrated and cited studies in the discussion about dividend payment policies.
Firstly there are theoretical assumptions for the model they construct. They assume “perfect capital markets [e.g. no transaction costs and no tax differentials], rational behavior [of participants in the financial markets], and perfect certainty [of all investors concerning future investment policy and profits]”3.
Given these assumptions one can make the statement that it is irrelevant whether a company retains earnings or distributes a dividend to its shareholders. That is the case because retained earnings increase the company’s capital assets. If the company pays dividends the stockholder receives a payment equal to the amount that the company’s value would have appreciated, had the earnings been retained2. The simple conclusion I draw from this model is, that it should be irrelevant for the shareholder whether he holds a share with the value of 100 or a share with the value of 95 with an additional 5 in form of a dividend payment.
Under the aforementioned assumptions the model holds. Of course it can be argued that the assumptions are unrealistic in their nature, which leads to the following statements among others2.
Investment policies and especially profits are really not certain, which is why high dividend payments might signal investors that the company has an optimistic opinion regarding future profits while low dividends would indicate the opposite. Thus high dividend payments might increase an investor’s willingness to pay for a stock and drive up its value.
Moreover an investor does face transaction costs in reality. An investor who relies on current income might value stocks higher when they pay a certain amount of dividend regularly, to avoid incurring additional brokerage fees by selling a portion of his shares every so often.
Furthermore the Modigliani Miller Model assumes that new equity can be issued at the market price and without additional costs. In reality companies that pay more dividends might have to raise more money by means of equity issues, which are subject to underpricing because of asymmetrical knowledge of investors and incur additional costs of e.g. hiring an underwriter. This makes retaining earnings the more favorable practice and investors might reward that practice by valuing companies with a no-dividend policy higher.
As a conclusion there are several aspects that might slant the impact of dividend payment policies towards being favorable or non favorable. The first to arguments suggest that dividend payments increase firm value while the last one indicates that dividend payments might have a negative impact. There are more factors, including the effect of tax rates (more in detail later). Nevertheless the theory of Modigliani and Miller should not be dismissed as irrelevant but should be kept in mind, as it is serves as an important basis for developing an understanding of the impact of dividend payment policies. Slowly loosening the framework assumptions made in the model and analyzing how the theory holds up can improve the understanding.
Moving on from this broad overview of theoretical impacts of dividend policies, let us have a look at the actual dividend payment process and its immediate influence on the stock price. While discussing the topic I want to refer to an article from the NASDAQ about the (in my opinion) somewhat dubious strategy of “dividend capturing”4.
The article starts off, by explaining that a simple strategy for investors, who are determined to find a way to generate a high rate of income, is to capture the dividend payments of companies with a high-level dividend yield. The strategy is exercised by buying high dividend stocks in the period before the ex-dividend date to be entitled to receiving the dividend and then selling it again either on the ex-dividend date or afterwards. Only later in the article does the author mention the very obvious and significant drawback of the according price drop of the share on the ex-dividend date that every shareholder, who is eligible for dividend payments, has to face. In addition to this misleading argumentation I want to point out that the author misrepresents the process of the price adjustment. When a company makes a dividend payment this reduces the amount of retained earnings directly and therefore decreases equity. Following the assumption that we operate in a close to efficient market, investors automatically account for the reduced amount of equity and assign the stock a lower price when the markets open on the ex-dividend date. The author however claims that the company reduces the price on the ex-dividend date on purpose to reward long-term shareholders, which makes no sense.
Moreover there are disadvantages to the strategy. Firstly investors are only eligible for paying a lower tax rate than their usual income tax rate if they receive a “qualified dividend”, which is only possible if the share is held a total of 60 days in the 121 day period, starting exactly 60 days before the ex-dividend date (explanation by the NASDAQ not quite correct either).
Secondly a trader that trades in such short terms faces significant transaction fees, which further drive down the return on investment considerably. Thus I have to give the investment strategy of dividend capturing (at least as it is explained by the NASDAQ) a rather desolate rating.
The only reason why the strategy could possibly produce significantly positive returns is mentioned in the first sentence of the paragraph “market action”: “Most capture strategists are counting on the stock price to not fall by the entire amount of the dividend due to external market forces”4. However it is not stated what kind of external forces the author refers to.
To talk about this interesting statement I first want to briefly introduce the third source and elaborate on the statement during the discussion of this source. The third source advocates the opposite opinion, being that an investor should invest in a stock on or after the ex-dividend date5. The first important point the article mentions is that the value of the share drops less than the absolute dividend payment, as the drop is “closer to the after-tax value of the dividend“5. As discussed before the tax rate varies for different investors. So let us assume the value will only drop by the average tax rate: Dividend*(1-average tax rate), which we will assume at 15%. This could potentially give a dividend capturer following the “NASDAQ theory” an advantage if he is paying fewer taxes than the average (e.g. only 10%). Because if he gets a dividend of one dollar he will receive 90ct of it after tax and the stock price will only drop by 85ct leaving him with a profit of 5ct per share. This is the only thing I could imagine the NASDAQ refers to when making the quoted statement. The only other case in which it would make sense to pursue the “NASDAQ-strategy” was if the stock were to produce abnormal returns preceding the period of the ex-dividend payment, because a significant number of people pursue the strategy, hence driving the stock price up. This assumption cannot be made without further statistical analysis.