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Rules of the Harvest: Dividend Policy and Shareholder Return
Chapter 8. Rules of the Harvest: Dividend Policy and Shareholder Return
After a long season of hard work, it’s time to harvest. For a company, this means deciding what to do with its “Net Income.” Should it reinvest every penny into new growth, or should it return some of that wealth to the people who own the company—the shareholders?
Dividend Policy is not just a simple payout; it’s a powerful communication tool that speaks volumes about a company’s past, present, and future.
1. The Great Debate: Does Dividend Matter?
Can a company increase its total value just by changing its dividend payout? Philosophically, there are two opposing views.
(1) Dividend Irrelevance (MM Theory)
Modigliani and Miller argued that in a perfect market, the value of a firm is determined by its investment policy (how it earns money), not its dividend policy.
- To a shareholder, a 1 increase in stock price. ==“It doesn’t matter how you slice the harvest.”==
(2) Bird-in-the-Hand Theory
Many investors prefer a “bird in the hand” (a certain dividend now) over “two in the bush” (uncertain future capital gains).
- Higher dividends reduce uncertainty and can lower the cost of equity.
2. Payout Methods: Dividends vs. Buybacks
In the modern era, “Share Buybacks” have become just as important as traditional dividends.
Comparison of Payout Methods
| Method | Action | Shareholder Impact |
|---|---|---|
| **Cash Dividend** | Distributes cash directly | Immediate cash, but stock price drops |
| **Share Buyback** | Company buys its own stock | Reduces shares, increases EPS and price |
Company generates surplus cash after all (+) NPV investments
Choosing a payout level to signal confidence in future growth
Determining if shareholders prefer dividends or capital gains (Tax Clientele)
Executing the payout via bank transfers or market purchases
3. Why Dividends are “Sticky”
Companies hate cutting dividends. Why? Because of the Signaling Effect.
- Dividend Increase: “We are so confident in our future cash flows that we can afford to pay more!” (Stock price often rises)
- Dividend Cut: “We are in trouble and need to save cash.” (Stock price often crashes)
The Smoothing Effect: Managers try to maintain a stable dividend even when earnings fluctuate. They only raise dividends when they believe the increase is sustainable in the long term.
4. Conclusion: Sharing the Wealth
A mature company with fewer growth opportunities should return more cash to shareholders. A young, growing company should reinvest. The “Perfect Dividend Policy” is one that ==“Aligns with the company’s life cycle and shareholder expectations.”==
📚 Prof. Sean’s Selected Library
- [Dividend Policy: Its Impact on Firm Value] - Ronald Lease: A comprehensive academic study on how payouts affect market perception.
- [The Essays of Warren Buffett] - Lawrence Cunningham: Buffett’s famous explanation on why Berkshire doesn’t pay dividends but loves buybacks.
- [A Random Walk Down Wall Street] - Burton Malkiel: Context on how the “Dividend Yield” factor performs in different market cycles.
Next time, we will move into the world of ‘Derivatives and Risk Management’—learning how to use options and futures to protect a business from a chaotic world.