Management determines its dividend policy by evaluating many factors, including:
- the tax differences between dividend income and capital gains,
- the need to generate internal funds to retire debt or invest, and,
- the desire to keep dividends relatively constant in the face of fluctuating earnings.
Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.
However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.
Dividend Payout Ratio
Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments.
The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.
Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.
How to value Stocks?
Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings.
Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)
John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote:
"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."
Ref: Stock for the Long Run, by Jeremy Siegel