Week 16 - Equity markets and stock valuation Flashcards
What does the fundamental theory of valuation state?
states that the value of any financial asset is equal to the present value (PV) of all its future cash flows, discounted at an appropriate rate that reflects the risk and time value of money.
What is a bond?
a fixed-income security that pays periodic interest (coupon payments) and returns the face value at maturity
What are two cash flows in bond valuation?
Coupons: Periodic interest payments made to bondholders
Face Value (Par Value): The amount repaid at the bond’s maturity
What discount rate is involved in bond valuation?
The yield to maturity (YTM) is used to discount future cash flows.
It represents the return an investor would earn if they held the bond until maturity.
What does stock valuation determine?
determines the intrinsic value of a company’s stock based on future expected cash flows
What cash flows are there in stock valuation?
Stocks do not have fixed cash flows like bonds.
Instead, cash flows come from dividends (for dividend-paying stocks) or expected future earnings.
What discount rate is involved in stock valuation?
The required rate of return (r) is used as the discount rate.
It depends on the risk level of the stock and is often estimated using models like the Capital Asset Pricing Model (CAPM).
What is a special dividend?
A one-time payment, separate from regular dividends.
Usually occurs when a company has unexpected profits or sells a large asset.
What is a liquidating dividend?
Paid when a company is shutting down or selling assets.
Often a return of capital rather than a share of profits.
What is a stock dividend?
Instead of cash, shareholders receive additional shares of stock.
Typically expressed as a percentage (e.g., a 10% stock dividend means you get 10 extra shares for every 100 shares you own).
No immediate cash gain, but increases the number of shares held.
What is a cash dividend?
The most common type of dividend.
Paid in cash directly to shareholders.
Typically distributed on a per-share basis.
What are two main ways you can receive cash when you buy a share of common stock?
Dividends – The company may pay periodic cash dividends to shareholders
Capital Gains – You can sell the stock at a future price, hopefully at a higher value than your purchase price.
As with bonds, what is the stock price?
present value of these
expected cash flows (dividend + expected price)
dividends could be in different forms:
we focus on cash dividend
What are 4 challenges in stock valuation (more difficult to value than a bond)?
- no promised cash flows
- cash flows are unknown in advance
- no maturity date (infinite life)
- the rate of return required by investors is unobservable
Why are there no promised cash flows in stock valuation?
Unlike bonds, which have fixed coupon payments and a guaranteed face value at maturity, stocks have no fixed cash flows.
Dividends can be irregular or nonexistent, making valuation difficult.
Why are cash flows unknown in advance in stock valuation?
Future dividends depend on company performance, profitability, and management decisions.
Some companies reinvest profits instead of paying dividends, further complicating valuation.
Why is there no maturity in common stock?
Unlike bonds, which mature at a specific date, stocks theoretically last forever.
This means valuation relies on estimating an infinite series of cash flows, which is complex.
Why is the rate of return required by investors unobservable?
The discount rate (r) used to value stocks is not directly observable.
It depends on investor expectations, risk preferences, and market conditions.
Small changes in r can significantly impact stock price estimates.
One period example:
You are thinking of purchasing a share of stock. You expect it to pay a £2
dividend in one year and you believe that you can sell the stock for £14 at
that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay
The stock price today is the present value of the expected cash flows (dividend + future stock price):
P_0 = (D_1 + P_1)/ 1+r
r= required rate of return
P_0 = 2+14/1.2 = 13.33
the maximum price you should be willing to pay today for this stock is £13.33.
One period example:
You are thinking of purchasing a share of stock. You expect it to pay a £2
dividend in one year and you believe that you can sell the stock for £14 at
that time. If you require a return of 20% on investments of this risk, what if P1 (14) is unknown?
P1 depends on P2
P1 = (D2 +P2)/ (1+r)
if D2, P2, and r are known, P1 can be worked out.
Remember that our goal is price today, i.e. P0 Substituting P1 into the formula of P0, we have:
P_0 = (D_1 + P_1)/ 1+r
P_0 = (D1 + (D2+P2/1+r))/ 1+r
P_0 = D1/ (1+r) + D2/ (1+r)ˆ2 + P2/ (1+r)ˆ2
Example 2 periods:
You decide to hold the same share for two years
D1 = £2.00 (expected dividend at D1)
D2 = £2.10 (expected dividend at D2)
P2 = £14.70 (expected selling price at P2)
How much would you be willing to pay today?
P_0 = D1/ (1+r) + D2/ (1+r)ˆ2 + P2/ (1+r)ˆ2
P_0 = 2/(1+0.2) + 2.1/(1+0.2)ˆ2 + 14.7/(1+0.2)ˆ2 = 13.33
What if you decide to hold the stock for three years?
D1 = £2.00 (expected dividend at D1)
D2 = £2.10 (expected dividend at D2)
D3 = £2.205 (expected dividend at D3)
P3 = £15.435 (expected selling price at P3)
How much would you be willing to pay today?
P_0 = D1/ (1+r) + D2/ (1+r)ˆ2 + D3/ (1+r)ˆ3 P3/ (1+r)ˆ3
P_0 = 2/(1+0.2) +2.1/(1+0.2)ˆ2 + 2.205/(1+0.2)ˆ3 + 15.435/(1+0.2)ˆ3 = 13.33
What do we find as we push back the selling time?
we find that the stock price today (P_0 ) is just the present value of all expected future dividends:
P_0 = D1/ (1+r) + D2/ (1+r)ˆ2 + D3/ (1+r)ˆ3 P3/ (1+r)ˆ3
= T∑t=1 D_t/(1+r)ˆt +P_r/(1+r)ˆT
Why does the selling price become irrelevant?
P_0 = ∞∑t=1 D_t/(1+r)ˆt
When we set
𝑡→∞ the term representing the present value of the selling price in the distant future approaches zero
This happens because the denominator grows exponentially, making any finite numerator insignificant.
What are the key dates of dividend payments?
- Declaration date
- Ex-dividend date
- Record date
- Payment date
What is the declaration date?
The company announces the dividend and sets the payment schedule.
What is the ex-dividend date?
The stock starts trading without the right to receive the declared dividend.
Investors who buy on or after this date will NOT receive the dividend.
Stock price typically drops by the dividend amount on this day.
What is the record date?
The company checks its records to see who is eligible for the dividend.
Investors must own shares before the ex-dividend date to be on the record.
What is the payment date?
The dividend is paid out to eligible shareholders.
Why does the share price fall on the ex dividend date?
Since new buyers the ex dividend date don’t get the dividend, the stock becomes less valuable.
The drop is usually about equal to the dividend amount but can be affected by market forces.
What are 3 key points in relation to this model? P0 = ∞∑t=1 D_t/(1+r)ˆt
- The stock price is ex dividend
- the stock price is independent of holding period
- firms are assumed to survive indefinitely
Why is the stock price an ex dividend?
The formula assumes we are valuing the stock just after the current dividend has been paid.
The next dividend, D1, is the first one considered in the valuation.
Why is the stock price independent of holding period
Whether an investor holds the stock for 1 year or forever, the price remains the same.
This is because the value comes from all future dividends, which are factored into today’s price.
Why are firms assumed to survive indefinitely?
The model does not account for bankruptcy, which is why it works best for stable companies with long-term growth.
Why do some stocks in companies have no dividends and still have positive prices?
Many companies, especially tech and internet stocks, don’t pay dividends but are still valuable due:
1. future growth expectations (Investors believe these companies will generate earnings and eventually pay dividends or reinvest in growth)
2. capital gains potential (Even without dividends, stockholders can profit by selling at a higher price in the future.)
and others…
What are the 3 key special cases to estimate dividends based on the growth assumptions of a company’s dividend payments?
- constant dividend/ zero growth
- constant dividend growth
- supernormal growth (differential growth)
What is constant dividend/ zero growth?
Assumption: The firm pays a constant dividend forever.
Example: Preferred stocks, where the company commits to paying the same dividend each period without any increase.
Formula:
The price is computed using the perpetuity formula:
P_0 = D/r
What is constant dividend growth?
Assumption: The firm increases dividends by a constant percentage every period, making it a growth stock.
Example: Many mature companies (e.g., Coca-Cola, Procter & Gamble) that steadily increase dividends over time.
What is supernormal growth (differential growth)?
Assumption: The firm has non-constant growth in dividends initially, but the growth rate settles down to a constant rate after a few periods. This model is often used when a company is in its growth phase but is expected to stabilise after some time.
Example: A tech company that grows rapidly at first but eventually slows down to a steady, predictable rate.
Why does the zero growth model use the perpetuity model?
we assume that dividends will remain the same level forever
D1= D2 = D3… = D = constant
since future cash flows (dividends) are constant, the value of a zero-growth stock is the present value of perpetuity
P_0 = D/ (1+r) + D/ (1+r)ˆ2 + D/ (1+r)ˆ3
The stock can be considered a perpetuity since the payments continue indefinitely and can be viewed as an ordinary perpetuity with a cash flow equal to D every period:
P0 = D/r
Zero-growth model example:
1. Suppose a stock is expected to pay a £0.50 dividend every quarter, and the required return is 10% with quarterly compounding. What is the price?
- Given no change in the required return, what will the stock be worth in one quarter?
- P0 = D/r = 0.5/(0.1/4) = 20
- P1 = D/r = 0.5/(0.1/4) = 20
Constant Dividend: Since the dividend is fixed and the required return does not change, the stock price will always remain the same at £20, barring any changes to the required return.
No Capital Gains: There are no capital gains to expect because the stock is not appreciating in value, only providing steady income from the dividends.
The price can only change if the required return r changes (e.g., due to changes in market conditions or interest rates).
Zero growth model example:
The common stock of Green Garden Flowers is selling for £24 a share.
The company pays a constant annual dividend and has a total return of
3.8 per cent. What is the amount of the dividend?
P0 = D/r
P0 = 24, r = 3.8%
D = P0 x r = 24 x 0.038 = 0.912
What is the gordon growth model/ dividend growth model formula?
Pt = D_t+1/ (r-g)
Pt - price of the stock today present value
D1 - the dividend expected in the next period (typically the next year)
r - required rate of return
g - constant growth rate of dividends
What is the gordon growth model/ dividend growth model used to calculate and used for?
used to calculate the price of a stock based on the assumption that dividends will grow at a constant rate indefinitely.
This model is widely used for valuing stocks that are expected to experience a constant growth rate in dividends. It’s particularly suitable for mature companies with stable dividend growth.
What are 3 assumptions of the gordon growth model/ dividend growth model?
Constant Dividend Growth: The dividend grows at a constant rate g indefinitely.
Required Rate of Return: The investor’s required rate of return r is constant and greater than the dividend growth rate g (i.e., r>g).
Stable Business: The model works best for companies that have mature, stable earnings and are likely to increase dividends consistently over time.
Dividend growth rate = stock price growth rate
If D1 = £4, r = 16%, g = 6%, what is the value of the stock today? In 4 years?
P0 = D1/r-g = 4/0.16-0.06 = 40
P_t = D_t+1 / (r-g) ->
P_4 = D5/ (r-g)
= D1x(1+g)ˆ4/ r-g
= 4 x (1+0.06)ˆ4/ 0.16-0.06
= 5.05/0.1
= 50.5
P_4 = D1/(r-g) x(1+g)ˆ4
= P0x(1+g)ˆ4
= 40 (1+0.06)ˆ4
= 50.5
The stock price in Gordon Growth model is growing at the same rate as the
dividend does
What are 6 key conditions the constant growth dividend discount model/ gordon growth model is based on?
- the dividend is expected to grow at rate g forever
- stock price expected to grow at g forever
- expected dividend yield is constant
- expected capital gains yield is constant and equal to g
- expected total return, r, must be >g
- expected total return (r) = expected dividend yield (DY) + expected growth rate (g) = DY + g
What does it mean when dividends grow at a constant rate (g) forever?
this means the company’s dividend policy follows a stable and predictable growth trajectory
Why is the stock price expected to grow at the same rate (g) forever?
since the stock price is based on expected future dividends, its value also increases at the same constant rate
Why is the expected dividend yield is constant?
the dividend yield (D1/P0) remains unchanged over time
Why is the expected capital gains yield constant and equal to the growth rate (g)?
the capital gains yield, which represents the appreciation in stock price, remains equal to g
Why must the expected total return (r) be greater than the growth rate (g)?
This ensures that the denominator (r-g) in the valuation formula doesnt approach zero or become negative, which would invalidate the model
What is the expected total return (r) formula?
r = dividend yield + g
r = D1/P0
D1 - expected dividend in the next period
P0 - current stock price
g - constant growth rate of dividends
r - the required rate of return or discount rate
This model is particularly useful for valuing stocks of companies with stable and predictable dividend growth, such as blue-chip companies. However, it does not work well for firms with irregular or highly variable dividend patterns.
How can the components of the expected return in the Constant growth model (Gordon growth model) be broken down?
Starting with the constant growth model formula:
P0 = D1/ (r-g)
P0 - current stock price
D1 - dividend expected in the next period
r - required rate of return (expected total return)
g - constant dividend growth rate
Rearrange:
r = D1/P0 + g
r = D1/P0 + (P1-P0)/P0
Expected return = Dividend Yield + Capital gains yield
g = D1-D0/D0
g = P1-P0/P0
Suppose a firm’s stock is selling for £10.50. They have just paid a dividend of £1 and dividends are expected to grow at 5% per year
- What is the expected return?
- What is the dividend yield?
- What is the capital gains yield?
- D0 = 1
D1 = D0 x (1+g)
D1 = 1 x (1+0.05)
D1 = 1.05
R = D1/P0 + g
R = 1.05/10.5 + 0.05
R = 0.15
- DY = D1/P0
DY = 1.05/10.5
DY = 0.1 - g = 0.05
Suppose Company A just paid a dividend of £0.60. It is expected to increase its
dividend by 3% per year. If the market requires a return of 20% on assets of this risk,
how much should the stock be selling for?
Dividend growth model (Gordon growth model):
P0 = D1/ (r-g)
D0 = 0.6
g = 0.03
r = 0.2
D1 = D0 (1+g)
D1 = 0.6 (1.03)
D1 = 0.618
P0 = 0.618/(1.2-0.03)
P0 = 3.64
stock should be selling for £3.64
Suppose Company A is expected to pay a dividend of £0.60. It is expected to increase its dividend by 3% per year. If the market requires a return of 20% on assets of this risk, how much should the stock be selling for?
D1 = £0.60
g = 0.03
r = 0.2
P0 = D1/(r-g)
P0 = 0.6/(0.2-0.03)
P0 = 3.53
stock should be selling for £3.53
Explain stock price sensitivity to required return on a graph
X-axis: Required return (r)
Y-axis: Stock price (P0)
The curve is downward sloping, showing that as r increase, P0 decreases
Stock price falls as required return increases:
When investors demand a higher return due to higher risk, the stock price drops.
Example: If interest rates rise, investors require a higher return, lowering stock valuations.
Stock Price is highly sensitive when r is close to g:
If r is only slightly above g, the denominator (r−g) is small, making P0 very large.
Small increases in r cause big drops in P0.
If r approaches g, the stock price explodes:
As r→g, the denominator shrinks, pushing P0 higher.
If r=g, the formula breaks down (division by zero).
If r is too high, the stock price collapses:
If r≫g, the denominator is large, making P0 very small.
Investors heavily discount the future dividends.
Explain stock price sensitivity to growth rate on a graph
X-axis: Dividend growth rate (g)
Y-axis: Stock price (P0)
The curve is downward-sloping at first, but as g gets closer to r, the price shoots upward steeply
If g=r, the denominator (r-g) approaches zero, making P0 tend toward infinity (which is unrealistic)
If g>r, the model breaks down, as the stock price would be negative or undefined
Small changes in g have a large impact:
A slight increase in g significantly raises P0
A slight decrease in g significantly lowers P0
As g approaches r, the stock price becomes very large:
The stock price is very sensitive when g is close to r
Investors pay a premium for higher growth stocks
If g>r, the model fails:
The denominator becomes negative, which is unrealistic
This highlights the requirement that r>g always
When do we use the differential (multi-stage) growth model?
when a stock experiences different growth rates over time before settling into a constant growth rate, we use the differential (multi-stage) growth model to determine its value.
What are 3 key assumptions of the differential growth model?
- the company has high growth for a certain period (years 1 to T)
- After year T, it transitions into a constant growth phase
- We must discount both the individual dividends during the high-growth phase and the stock price at year T back at present value
What is the process to calculate differential growth?
- Assume that dividends will grow at different rates in the foreseeable future till year T and then will grow at a constant rate after year T
- To value a differential growth stock, we need to:
Estimate dividends into the foreseeable future (D1, D2, DT)
Estimate the future stock price when the stock becomes a constant growth stock ((PT) in case 2)
P_T = D_T+1/ (r-g)
compute the total present value of the estimated future dividends and future stock price at the appropriate discount rate
P0 = D1/(1+r) + D2/(1+r)ˆ2 _ D3/(1+r)ˆ3 +… D_T/(1+r)ˆT + P_T/(1+r)ˆT
D_T - the last dividend in the high-growth phase
P_T - in the stock price at year T, calculated using the constant growth model
Differential growth example:
Company K has just paid a dividend of £6.75 per share. You project its dividend
growth as follows, what should be the fair price of K today if R = 13.75%? (Assume constant growth of 5% since year 5).
Y0 -> g=0 D0 = 6.75
Y1 -> g=25% D1 = 8.45
Y2 -> g =20% D2 = 10.13
Y3 -> g=15% D3 = 11.64
Y4 -> g = 10% D4 = 12.812
Y5 -> g=5% D0 = 13.45
P0 = D1/(1+r) + D2/(1+r)ˆ2 _ D3/(1+r)ˆ3 + D4/(1+r)ˆ4 + P4/(1+r)ˆ4
P0 = 8.44/(1+0.1375) + 10.13/(1+0.1375)ˆ2 + 11.64/(1+0.1375)ˆ3 + 12.81/(1+0.1375)ˆ4 + P4/(1+0.1375)ˆ4
P4 = D5/(r-g)
P4 = 13.45/(0.1375-0.05)
P4 = 153.71
P0 = 122.62
What does “common” stock represent?
represents ownership in a company but doesnt have special privileges
unlike preferred stock, common stockholders are last in line for dividends and assets during bankruptcy
What 4 rights do common stockholders have?
- voting rights
- right to dividends
- rights to assets in liquidation
- pre-emptive right
How do shareholders control the corportation?
through the right to elect the directors
Stockholders elect the board of directors who hire managers
What voting rights do stockholders have?
Stockholders elect directors who oversee company management
Golden rule: one share = one vote (in most cases), but companies have different voting structures (eg dual-class shares)
Proxy voting
Classes of stock and unequal voting rights
How can small shareholders influence decisions?
small shareholders often dont own enough shares to individually influence decisions, they can combine their votes using proxy voting
What is proxy voting?
Shareholders transfer their right to vote to another party who votes on their behalf
When is proxy voting often used?
Often used when minority shareholders are trying to get enough votes to obtain seats on the Board (gain board representation) or to challenge company decisions and other important issues
Large investors or activist groups may gather enough proxies to push for changes in management or policies
What are classes of stock and unequal voting rights?
Not all stocks follow the one share, one vote rule. Some companies issue multiple classes of stock with different voting rights.
Owners issue a nonvoting class of stock to make sure that they maintain control of the firm
Why use different classes?
Founders and executives retain control while still raising money from investors
Protects against hostile takeovers
An example of classes of stock: Google
Class A shares: One vote per share (public investors).
Class B shares: 10 votes per share (held by founders & insiders, ensuring control).
Class C shares: No voting rights (used to raise capital without diluting control).
What are 3 dividend characteristics?
- dividends arent a liability until declared
- bankruptcy and dividends
- dividends and taxes
Why arent dividends a liability until declared
A dividend becomes a liability for the firm only once it is declared by the board of directors.
Before being declared, a dividend is merely a proposal and doesn’t legally bind the company.
No bankruptcy risk arises from failing to declare a dividend.
Why cant a firm go bankrupt for not declaring dividends?
Dividends are optional, and the decision to pay them depends on the company’s financial condition and strategy.
However, failing to pay dividends could potentially hurt the company’s stock price or investor sentiment if shareholders expect regular payouts.
Why are dividends not tax deductible for the firm?
Unlike business expenses such as wages, dividends are not tax-deductible for the company.
This means that the company pays taxes on its income before distributing dividends to shareholders.
Example: A company earns $1,000 in profits, pays taxes on that amount, and then distributes dividends from the after-tax income.
How do individual shareholders receive dividends?
Dividends received by individual shareholders are taxed as ordinary income.
The tax rate on dividends depends on the individual’s tax bracket and whether the dividends are qualified or non-qualified (ordinary).
Qualified dividends (those from U.S. companies and held for a certain period) are typically taxed at a lower rate.
Non-qualified dividends are taxed at the regular income tax rate.
What is a right to dividends?
Shareholders share proportionally in any dividends declared by the board.
No guarantee of dividends—companies decide when and how much to pay.
What is a right to assets in liquidation?
If a company goes bankrupt, common shareholders get assets only after debt holders and preferred shareholders are paid.
Often, this means common shareholders get little or nothing.
What is a pre-emptive right?
Allows shareholders to buy new stock issues before the public to maintain their proportional ownership.
Protects against dilution (losing ownership percentage when new shares are issued).
What is preferred stock?
a type of equity that has preference over common stock in terms of:
1. Dividend payments
2. Claims on assets in case of bankruptcy
Preferred stockholders are paid before common stockholders in both cases, but after debt holders
What are the 3 dividend features of preferred stock?
- Not a liability
- Deferral of dividends
- Cumulative dividends
Why is preferred stock not a liability?
Like common stock, dividends on preferred stock are not a legal obligation for the company. They are discretionary until declared.
A company can choose not to pay dividends, but this will affect its stock price and investor relations.
What is the deferral of dividends?
Preferred stock dividends can be deferred indefinitely
However, even if the company defers the dividend, it does not mean it is erased. The company still owes the deferred dividends (especially if they are cumulative)
What are cumulative dividends?
Most preferred stock is cumulative, meaning that if the company skips a dividend payment, it accumulates and must be paid before any dividends can be paid to common shareholders.
For example, if a company misses a year’s preferred dividend, they must pay it in the future (along with any other accumulated dividends) before paying any dividends to common shareholders.
Why doesnt preferred stock generally carry voting rights?
Preferred stock generally does not carry voting rights, meaning preferred stockholders do not have a say in corporate governance or board elections.
However, there are some exceptional cases where preferred stockholders can gain voting rights, such as:
When dividends are missed for a certain period (e.g., 2 or more years).
Some companies issue participating preferred stock, which gives more rights under certain conditions.
What is the LSE
The London Stock Exchange (LSE) is one of the world’s largest stock markets. It operates with a variety of trading systems tailored to different types of securities.
What are 3 trading systems the London Stock Exchange (LSE) has?
- Electronic order book for large companies
- Hybrid system for mid-cap securities
- Quote-driven trading for smaller companies
What is the electronic order book (for large companies)?
The LSE has an electronic order book that facilitates the matching of buy and sell orders for the largest and most heavily traded companies (i.e., those with high liquidity and large market capitalisation).
What is the hybrid system for mid-cap securities?
For mid-cap (medium capitalisation) companies, the LSE uses a hybrid system, which combines both market-based trading and an order book. This helps balance the flexibility of market makers with the efficiency of electronic matching.
What is quote drive trading (for smaller companies)?
For smaller companies, the LSE relies more on quote-driven trading, where market makers provide bid and ask prices, and buyers and sellers match based on those quotes. Smaller companies may have less liquidity, so market makers help ensure that trades happen.
What is the NYSE?
The New York Stock Exchange (NYSE) is another major stock exchange that has evolved over time, integrating both traditional and modern trading methods.
What 3 trading systems does the New York Stock Exchange (NYSE) have?
- Floor based auction market trading
- Automatic execution for orders
- Centralised point of sale
What is floor-based auction market trading?
Traditionally, the NYSE operated with floor-based trading, where human brokers and specialists met in a physical space to match orders in an auction-like environment. While electronic systems have since taken over a lot of trading, the auction market feature remains for certain trades.
What is automatic execution for orders?
In addition to human interaction, orders at the NYSE can be executed automatically for certain transactions. For example, around 10% of orders are executed automatically through the exchange’s electronic systems without the need for a human broker’s intervention.
What is the centralised point of sale?
Investor orders are delivered electronically to the NYSE’s central system, where they are matched with buy and sell orders. This centralisation helps create efficient markets.
Why do dividends matter?
Dividends are important because they impact the value of the stock.
The stock price is influenced by the present value of expected future dividends. This means investors often view dividends as a key indicator of a company’s financial health and future prospects.
Dividends provide immediate returns to investors, and they are an important part of the total return (dividends + capital gains).
What is dividend policy?
Dividend policy is essentially the decision a company makes between paying dividends or retaining earnings (funds) to reinvest in the firm.
Why may dividend policy not matter?
Theoretically, in a perfect market, it doesn’t matter whether a company pays dividends or not because investors can sell some of their shares to generate income if needed.
The decision could affect stock price only if investors prefer cash payouts or if the reinvested capital is expected to produce greater future returns.
What are 3 factors favouring a low dividend payout?
- Taxes
- Flotation costs
- Dividend restrictions (debt covenants)
How do taxes favour a low dividend payout?
Tax Treatment of Dividends vs. Capital Gains:
In many tax systems, dividends are taxed at a higher rate than capital gains.
As a result, investors may prefer capital gains over dividends because they face lower taxes on the appreciation in stock price.
To avoid tax inefficiencies, companies might prefer to retain earnings and reinvest them, rather than paying out high dividends.
What are flotation costs?
Flotation costs are the expenses incurred when a company issues new securities to raise capital (such as issuing new shares or bonds).
Why do flotation costs favour a low payout?
If a company has a high dividend payout, it may need to raise more capital to finance operations or investments.
Lower payouts can reduce the amount of external capital the company needs to raise, which can help reduce flotation costs.
Lower flotation costs = more retained earnings for reinvestment and growth, which can be more efficient in the long run.
What are debt covenants
Companies with debt often face debt covenants, which are restrictions set by lenders that limit the amount of dividends a company can pay out.
Why do dividend restrictions (debt covenants) favour a low payout?
Debt covenants ensure that the company retains enough earnings to meet its debt obligations.
Debt covenants may limit the percentage of income that can be paid out as dividends.
If the company has a high level of debt or specific restrictive covenants, it may be forced to pay lower dividends to avoid breaching these agreements.
What are 3 factors favouring a high dividend payout?
- Desire for current income
- Uncertainty resolution
- Taxes
Why does a desire for current income favour a high dividend payout?
Individuals in Low Tax Brackets:
For individuals in low tax brackets, dividends are often taxed at a lower rate than capital gains. Thus, receiving dividends may be more beneficial than selling stocks for capital gains.
Income Requirements (e.g., Pensioners):
Some investors, such as pensioners or people who rely on their investments for income, may prefer high dividend payouts because they need steady cash flow for living expenses.
Why Not Sell Stocks Directly?:
Instead of selling shares to generate income, these investors may prefer receiving dividends because it provides a more predictable and regular income stream. Selling stocks can trigger capital gains taxes and market timing risks.
Why does uncertainty resolution favour a high dividend payout?
Future Uncertainty:
There is no guarantee that the company’s future dividends will increase or that the stock price will appreciate.
By paying high dividends, companies provide investors with a portion of the return on their investment now, reducing some of the uncertainty about future returns.
Investors who rely on income may prefer a high payout to ensure they get returns, even if future capital gains or dividends are uncertain.
Why do taxes favour a high dividend payout
Tax Planning (e.g., UK):
In some countries, such as the UK, there may be tax advantages to dividends over capital gains. Investors in certain tax environments may prefer high payouts as part of their tax strategy, where dividends are taxed more favorably than capital gains.
Tax-Exempt Investors:
For tax-exempt investors (e.g., charities or pension funds), dividends versus capital gains might be irrelevant because they do not pay taxes on either. These investors might favor high dividend payouts as a way to receive income without worrying about tax implications.
5 points to summarise dividends
- The total amount of dividends paid out is high
- Dividends are heavily concentrated among a small number of large firms
- Managers are very reluctant to cut dividends
- Managers smooth dividends, raising them slowly as earnings grow
- Stock prices react to unanticipated changes in dividends
What are 3 key theories for paying dividends?
- To reduce agency problems
- Signalling theories
- Clientele theories
Why does paying dividends reduce agency problems?
Higher Dividend Payouts Reduce Agency Costs:
A higher dividend payout forces the company to raise more funds externally. This leads to more scrutiny from investors, analysts, and external parties, as they want to ensure the company is being managed effectively.
This scrutiny can reduce agency costs, as management may be more incentivised to act in the best interest of shareholders when they know their actions will be closely observed.
Essentially, paying dividends limits the ability of management to misuse funds since excess cash is paid out, leaving less room for wasteful spending or inefficient projects.
What is signalling?
Managers may use dividends as a signal to the market about their knowledge of the company’s future prospects.
Why does increasing dividends act as a signal?
By increasing the dividend, managers signal to investors that they are confident about the firm’s future profitability and cash flows.
Investors often interpret an increase in dividends as a positive indicator that the company is in good financial health and expects to generate sufficient profits going forward.
Conversely, if a company cuts its dividend, it can signal to the market that management is worried about the company’s future earnings or cash flow.
What is the clientele effect?
Different types of investors (clients) have different preferences when it comes to dividend policies. The clientele theory suggests that companies will attract a specific group of investors based on their dividend policies
Why does clientele theories help pay dividends?
Different Investor Preferences:
Income-focused investors (like pensioners) might prefer high dividend payouts for regular income.
Growth-focused investors, on the other hand, may prefer low dividend payouts so the company can reinvest those earnings to fuel growth.
Stable Dividend Policies: Companies that maintain a consistent dividend policy may build a loyal investor base that prefers that specific type of dividend payout.
Changing Dividend Policy: If a company suddenly changes its dividend policy, it could lead to the loss of its current investor base and may cause stock price volatility.
What are 5 pros of paying a dividend?
- Cash Dividends Underscore Good Results and Support Stock Price:
Dividends signal financial health. Paying dividends shows that the company is generating sufficient profits and cash flow, which can boost investor confidence and support the stock price. - Attracts Institutional Investors:
Companies that pay consistent dividends tend to attract institutional investors, such as pension funds and mutual funds, which often prefer stable, predictable income from dividends. - Stock Price Usually Increases with New or Increased Dividends:
When a company announces a new dividend or increases an existing one, the stock price often rises. Investors may view this as a signal of a company’s positive future outlook or strong cash flow. - Reduces Agency Costs:
By paying out dividends, a company limits the amount of retained earnings that management can use for inefficient projects or excessive spending, thereby reducing agency problems and encouraging better decision-making. - Absorbs Excess Cash:
If a company has excess cash (i.e., funds that aren’t needed for immediate investment opportunities), paying dividends is a way to distribute that cash to shareholders rather than letting it sit unused, which could lead to inefficiency or waste.
What are 3 cons of paying dividends?
- Dividends are Taxed to Recipients (Double Taxation):
Dividends are taxed twice: once at the corporate level (the company pays taxes on its profits), and again at the individual level when shareholders receive the dividends. This is often referred to as double taxation and can reduce the overall return to investors compared to capital gains. - Dividends Can Reduce Internal Sources of Funding:
Paying dividends reduces retained earnings, which could otherwise be reinvested in the business. This means the company might have to forgo promising growth projects or research and development (R&D) opportunities in favor of paying dividends.
May Require External Financing:
If a company pays out a high proportion of its earnings as dividends, it may not have enough internal cash to fund new investments or expansion. This could require the company to seek external financing (e.g., issuing new stock or taking on debt), which may be costly or dilute existing shareholders. - Dividend Cuts Can Adversely Affect Stock Price:
Once a company has established a dividend policy, cutting the dividend (even if it’s necessary due to financial challenges) can harm the stock price. Investors often view a dividend cut as a sign of weakness or financial trouble, which may lead to loss of investor confidence and a decline in the stock price.
