What Is Dividend Irrelevance Theory?
Dividend irrelevance theory posits that dividends don’t have any effect on a company’s stock price. A dividend is typically a cash payment made from a company’s profits to its shareholders as a reward for investing in the company.
Dividend irrelevance theory goes on to state that dividends can hurt a company’s ability to be competitive in the long term since the money would be better off reinvested in the company to generate earnings.
Although there are companies that have likely opted to pay dividends instead of boosting their earnings, there are many critics of dividend irrelevance theory who believe that dividends help a company’s stock price to rise.
Key Takeaways
- Dividend irrelevance theory suggests that a company’s dividend payments don’t add value to a company’s stock price.
- Dividend irrelevance theory also argues that dividends hurt a company since the money would be better reinvested in the company.
- The theory has merits when companies take on debt to honor their dividend payments instead of paying down debt to improve their balance sheet.
Understanding Dividend Irrelevance Theory
Dividend irrelevance theory suggests that a company’s payment of dividends should have little to no impact on the stock price. If this theory holds true, it would mean that dividends do not add value to a company’s stock price.
The premise of the theory is that a company’s ability to earn a profit and grow its business, not dividend payments, determines a company’s market value and drives the stock price. Those who believe in dividend irrelevance theory argue that dividends don’t offer any added benefit to investors and, in some cases, argue that dividend payments can hurt the company’s financial health.
Dividend irrelevance theory was developed by economistsMerton MillerandFranco Modiglianiin 1961. The duo are also responsible for the Modigliani-Miller theorem.Both were awarded the Nobel Prize in Economics.
Dividends and Stock Price
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. In other words, if the stock price was $10, and a few days later, the company paid a dividend of $1, the stock would fall to $9 per share. 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.
However, stocks that pay dividends, like many established companies called blue-chip stocks, often increase in price by the amount of the dividend as the book closure date approaches. Although the stock can decline once the dividend has been paid, many dividend-seeking investors hold these stocks for the consistent dividends that they offer, which creates an underlying level of demand.
Also, the stock price of a company is driven by more than the company’s dividend policy. Analysts conduct valuation exercises to determine a stock’s intrinsic value. These often incorporate factors, such as:
- Dividend payments
- Financial performance
- Qualitative measurements, including management quality, economic factors, and an understanding of the company’s position in the industry
Dividends and a Company’s Financial Health
Dividend irrelevance theory suggests that companies can hurt their financial well-being by issuing dividends, which is not an unprecedented occurrence.
Taking on Debt
Dividends could hurt a company if the company is taking on debt, in the form of issuing bonds to investors or borrowing from a bank’s credit facility, to make their cash dividend payments.
Let’s say that a company has made acquisitions in the past that have resulted in a significant amount of debt on its balance sheet. The debt-servicing costs or interest payments can be detrimental. Also, excessive debt can prevent companies from accessing more credit when they need it most. If the company has a hard-line stance of always paying dividends, proponents of dividend irrelevance theory would argue that the company is hurting itself. Over several years, all of those dividend payouts could have gone to paying down debt. Less debt might lead to more favorable credit terms on the remaining outstanding debt, allowing the company to reduce its debt-servicing costs.
Also, debt and dividend payments might prevent the company from making an acquisition that might help increase earnings in the long term. Of course, it’s difficult to pinpoint whether dividend payments are to blame for a company’s underperformance. Mismanaging its debt, poor execution by management, and outside factors, such as slow economic growth, could all add to a company’s difficulties. However, companies that don’t pay dividends have more cash on hand to make acquisitions, invest in assets, and pay down debt.
CAPEX Spending
If a company is not investing in its business through capital expenditures (CAPEX), there could be a decline in the company’s valuation as earnings and competitiveness erode over time. Capital expenditures are large investments that companies make for their long-term financial health and can include purchases of buildings, technology, equipment, and acquisitions.
Investors that buy dividend-paying stocks need to evaluate whether a management team is effectively balancing the payout of dividends and investing in its future.
Dividend Irrelevance Theory and Portfolio Strategies
Despite dividend irrelevance theory, many investors focus on dividends when managing their portfolios. For example, a current income strategy seeks to identify investments that pay above-average distributions (i.e., dividends and interest payments). While relatively risk-averse overall, current income strategies can be included in a range of allocation decisions across a gradient of risk.
Strategies focused on income are usually appropriate for retirees or risk-averse investors. These income-seeking investors buy stocks in established companies that have a track record of consistently paying dividends and a low risk of missing a dividend payment.
Blue-chip companies generally pay steady dividends. These are multinational firms that have been in operation for a number of years, including Coca-Cola, PepsiCo, and Walgreens Boots Alliance. These companies are dominant leaders in their respective industries and have built highly reputable brands, surviving multiple downturns in the economy.
Also, dividends can help with portfolio strategies centered around the preservation of capital. If a portfolio suffers a loss from a decline in the stock market, the gains from dividends can help offset those losses, preserving an investor’s hard-earned savings.
Why do companies pay dividends?
Companies pay dividends as a way to share profits with shareholders. Not all companies pay dividends.
How are dividends paid?
In general, dividends are paid in cash. Dividend payments can also be reinvested in the stock distributing them to buy more shares.
Who is eligible for stock dividends?
Shareholders who buy or already own a company’s stock before the ex-dividend date will receive dividends on the date of payment.A company’s board of directors determines these dates.
The Bottom Line
Dividend irrelevance theory maintains that dividend payments don’t impact a company’s stock price. The theory was developed by economists Merton Miller and Franco Modigliani, both Nobel laureates.
The theory is not without its critics. For example, some maintain that a company’s ability to pay out regular dividends signals financial strength and sustainability to investors, which can positively impact a stock’s price.
