Overview
Companies that are successful will have a consistent pattern of positive earnings and net income. Part 5 of the Money Flow module discusses the firm's decision to use these financial resources (earnings and net income) to provide a return to its shareholders in the form of dividends versus retaining these resources and reinvesting them for future growth.
Understanding a few things at the outset:
- There exists no unified dividend theory applicable to the many distribution plans that characterize the payout policies of real world corporations. However, we are still able to identify some general distribution patterns and the policy factors behind these patterns.
- A firm's dividend policy should be one that attempts to maximize the value of the firm. Managers should aim for a target distribution policy—one that maximizes stock price over the long-term.
- Don't confuse the term dividend policy with a specific dollar dividend amount. The term "policy" refers to management's longer-run plan to distribute cash to shareholders, not a temporary or one-time dollar dividend payment. A dividend check is not equivalent to or necessarily reflective of a dividend policy.
- While we will concentrate on cash dividends in this part of the Money Flow lesson, understand that the term dividend policy also includes the firm's non-cash dividend practices as well. Both cash and non-cash policies are management-determined, are inter-connected, and both can impact firm value.
- Cash dividends constitute only one part of a stock's total dollar return, the other is expected capital gain. While the financial manager should attempt to maximize stock price, how the total return on the stock is divided between dividend yield (the rate of return due to the dividend) and capital gain yield (the rate of return due to appreciation of the firm's stock price in the market) is determined by many factors. Some of these factors can be controlled by management and some cannot.
- The dividend policy followed by management today reflects management's decision to trade expected growth in the future for a high payout today.This dividend tradeoff decision will attract different types of investors (different clienteles). While investors have a choice in how their total return on investment is received (by choosing firms with the dividend policy they like), firms have some control over how the total return on its stock is generated (high payout versus high expected capital appreciation).
The dividend decision can produce announcement effects. Management must consider these effects in the payout decision since these information by-products can impact the firm's stock price and ultimately its value.
