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Dividends Do Not Matter

The basis of the argument that dividends don’t matter is simple.

The financial theory, referred to as the Miller-Modigliani Theorem, stats that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends (source).

Remember, a firm can choose between three methods of financing:

1. Issuing shares
2. Borrowing
3. Spending profits (as opposed to dispersing them to shareholders in dividends)

The theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes NO difference whether a firm finances itself with debt or equity.

Firms that pay MORE dividends will offer LESS price appreciation and deliver the SAME total return to stockholders.

This is because a firm’s value comes from the investments it makes (plant, equipment and other real assets, for example) and whether these investments deliver high or low returns. If a firm that pays more in dividends can issue new shares in the market, raise equity, and take exactly the same investments it would have made if it had not paid the dividend, its overall value should be unaffected by its dividend policy. After all, the assets it owns and the earnings it generates are the same whether it pays a large dividend or not.

In Financial Innovations and Market Volatility, Merton Miller explains the concept using the following analogy:

“Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That’s the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M & M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk.”

You, as an investor, will also need to be indifferent between receiving dividends and capital gains for this proposition to hold. After all, if you are taxed at a higher rate on dividends than on capital gains, you will be less happy with the higher dividends, even though your total returns will be the same, simply because you will have to pay more in taxes.

For dividends to not matter, you either have to pay no taxes or pay the same taxes on dividends and capital gains. The assumptions needed to arrive at the proposition that dividends do not affect value may seem so restrictive that you will be tempted to reject it without testing it; after all, it is not costless to issue new stock and dividends, and capital gains and dividends have historically not been taxed at the same rate.

That would be a mistake, however, because the theory does contain a valuable message for investors:

  • A firm that invests in poor projects that make substandard returns cannot hope to increase its value to investors by just offering them higher dividends.
  • Alternatively, a firm with great investments may be able to sustain its value even if it does not pay any dividends.

Do you really think dividends do not matter? What are your thoughts on the Miller-Modigliani Theorem? Leave your comment below!

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