What is Dividend?

Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.

Dividend Decisions and Policies

The investor always expects a high amount of gain from their investments so companies always try to satisfy the need of their investor and value a good amount of return. In deciding the value, finance managers determine what proportion of the profit should be retained in the business and what should be distributed as dividends. The main objective of taking a decision is to maximize the wealth of the company's stockholders.

Optimal Dividend Policy

• When r>ke, dividend-paying is 0% and retention is 100%.
• When r<ke, dividend-paying is 100% and retention is 0%.
• When r=ke, dividend-paying decision does not affect the market price.

Here,

r= Internal rate of return and ke= Cost of capital/Required rate of return

It directly affects the other two decisions i.e., investment and finance. Optimal dividend policy is a subjective matter and many management authors have provided their model to determine it. Different approaches are as follows.

1. Walter Approach.
2. Modigliani and Miller Approach (MM).
3. Dividend Discount Model (DDM)
4. Lintner's Approach.

Understanding the Different Models

Walter Approach

Prof. James E. Walter has given this approach which focuses on how dividends can be used to maximize the wealth position of equity shareholders. Thus, dividend growth is received by the stockholders of the company. Assumptions of this model are as follow.

• Retained earnings are the only source of finance.
• The internal rate of return (r) & cost of equity (ke) is constant.
• The firm has perpetual life.

Formula:

Where,

P= Market price per share

D= Dividend per share

r= Internal rate of return

E= Earnings per share

K_e= Cost of equity capital 

Modigliani and Miller Approach

According to this approach, the policy has no impact on the value of the firm's share i.e., the decision of paying out or not is not relevant at all. This approach states that under the conditions of the perfect capital market, rational investors, absence of tax discrimination, given firm's policy may not influence the market price of shares. Assumptions under this approach are as follows.

• Investors are rational.
• No insider trading i.e., information is easily available to all the investors.
• Perfect capital market.
• No transaction cost.
• No taxation.
• According to the MM approach, the market price of the shares is the present value of all future cash flows.

Formula:

Where,

P₀= Current market price

D₁= Expected future dividend

P₁=Price of share at the end of period one

K_e= Cost of equity or discount rate

Note: As per this approach, the value of the firm will not change from the perspective of the company as well as the investors.

Dividend Discount Model

The dividend discount model (DDM) is generally a quantitative method of valuing a company’s stock price which is based on the assumption that the current fair price of a stock is equal to the sum of all of the company’s future dividends which is discounted back to their present value.

Formula

Where,

P= Current share price

g= Dividend growth rate (b*r)

K_e= Cost of capital or discount rate

D_i= Expected future dividend

b=Retention rate

r= Internal rate of return

Here, the time value of money is very essential and for understanding this, we have to first learn about future value and present value.

Future value is given as

Present value is given as

The dividend discount model has several variations depending on the assumptions.

Gordon Growth Model (GGM)

The Gordon Growth Model (GGM) model is one of the most commonly used variations of the dividend discount model for analysing its dividend growth rate. It is named after the American economist Myron. J. Gordon, who proposed this variation. The GGM helps an investor in evaluating a stock’s intrinsic value based on the potential dividend growth at a constant rate. The GGM is based on the assumption that the future dividends will grow at some constant rate in the future for an infinite number of periods. This model helps assess the value of businesses that have strong cash flow, steady levels of dividend growth rate, and have acquired stability. It takes an assumption that the company possesses a constant and stable business model and that the growth of the company occurs at a constant rate over time.

Formula

Where,

V₀ = The current fair value of stock

r = The estimated cost of equity capital

g = The constant growth rate of company's dividend for an infinite time.

D₁ = The dividend payment in one period.

One Period Dividend Discount Model (DDM)

The one-period dividend discount model is regarded as a variation of the dividend discount model. The one-period dividend discount variation is generally used in determining the intrinsic value of a stock that is planned to be held for a single period (usually one year). As in the case of the DDM model, the one-period variation is also based on the assumption that the intrinsic of a stock is equal to the sum of all future cash flows which is discounted back to its present value. It helps in calculating the dividend growth at a discount rate.

Formula: 

Where,

V₀ = The current fair value of stock.

D₁ = The dividend payment in one period.

P₁ = The stock price in one period from now.

r = Estimated cost of equity capital.

Multi-Period Dividend Discount Model (DDM)

A multiple-period dividend discount model is also a variation of the DDM model. It is mostly used in situations where an investor is expecting to buy a stock and is thinking of holding it for a finite number of years and then selling it at the end of the holding period. As in the case of the DDM model, the one-period variation is also based on the assumption that the intrinsic of a stock is equal to the sum of all future cash flows which is discounted back to its present value. DDM Model is based on the assumption that dividend grows at a required rate that remains constant till perpetuity.

Advantages of DDM

• Justification: The primary advantage of DDM is that the logic behind this theory is very simple and indisputable. In DDM, an investor buys a share and entitles the benefit from the company to perpetuity.
• No requirement of control: Minority shareholders have no control over the company as they have only dividends as a measure of valuation as they receive earnings on their investment consistently.
• Consistency: Most important advantage of DDM is that the dividend grows at a required rate remaining constant over a long period of time. Volatility is experienced by the company while measuring the earnings and free cash flows.
• No Subjectivity: No ambiguity is there in this model. There is subjectivity regarding the constitution of earnings and free cash flows, thus, analysts come up with a valuation of a company using the DDM model. Therefore, this lack of subjectivity makes the DDM more reliable and preferable.  

Disadvantages of DDM

• Too many assumptions: The dividend discount model is full of assumptions regarding dividend growth rate, discount rate, and tax rates. These factors are beyond the control of stockholders which reduces the validity of DDM.
• Limited use: The dividend discount model is used in matured and stable companies that have the capability of dividend payment consistently.
• Tax efficiency: In many countries, the tax structures are created in such a way that capital gains may be taxed lower than dividends. Also, many tax structures may encourage the repurchase of shares instead of paying out dividends. In these countries, most of the companies will not pay out dividends because it leads to dilution of value. Any stockholder who strictly believes in the DDM model will have no option but to ignore all the shares about that particular country. This is one more reason why DDM fails to guide investors.
• Control: Lastly, the dividend discount model does not apply to large stockholders. Since they buy a big stake in the corporation, they have some degree of control and can influence the payment policy if they want to. Thus, for them, at least, dividends are an irrelevant metric.

Lintner's Approach

John Virgil Lintner, Jr., a professor at the Harvard Business School in the 1960s proposed Lintner's model. According to Lintner's approach, the financial manager has long-term market payment ratios i.e., maintained dividend growth rate for the future. So, mature companies pay a high proportion of earnings, and growing companies pay a low proportion of earnings. The Lintner method is based on the assumption that a higher net present value indicated higher earnings and that the company's earnings may be increased without increasing its dividend pay-outs.

Financial managers are reluctant to reverse the decision taken last year i.e., if dividend per share (DPS) was $2 last year then, even if earnings are reduced, DPS cannot be reduced below $2 in the current year. Managers focus more on the absolute level rather than the dividend payment ratio.

Formula

Where,

D_t= Current year's dividend

c= Speed of adjustment

r= Payout ratio

EPS_t= The current year's earnings per share

D_t-1= Last year's dividend

Speed of adjustment shows the speed with which the current year's earnings will be available for dividend payments.

Context and Application

The topic is significant in the professional exams for both undergraduate and postgraduate courses, especially for

• B. Com (Bachelor of Commerce)
• BBA (Bachelor of Business Administration) in Finance
• MBA (Master of Business Administration) in Finance
• CA (Chartered accountant)
• CFA (Chartered Financial Analyst) Program