Dividend Policy Theory

We start our coverage of dividend policy theory with three extreme positions, labeled "basic views." These serve as benchmarks for thinking about the importance of dividend policy. They are all based on assumptions that leave out important pieces to the dividend puzzle. So after we cover them, we will proceed by taking into account some other factors that will help to "improve our thinking."

Three basic views

The three basic (and rather extreme) views of dividend policy are: dividends are irrelevant, higher dividends are always better than lower dividends, and lower dividends are always better than higher dividends. All of these views deal with how an investor is to receive her or his return. Stock returns come in two forms: dividend yield and capital gains through price appreciation. More dividends means less capital gains (since the price falls by the amount of the dividends), and leaving the money in the firm results in a higher stock price than if the money were paid out as dividends. So which do you want, dividend yield or capital gains? Let’s look at the way each theory answers this question.

• Dividends are irrelevant. The irrelevance theory says that the choice between dividends and capital gains does not matter since capital gains are a perfect substitute for dividends and vice versa. The argument is that a firm’s dividend policy cannot create or destroy value for a firm since any dividend policy can be undone or created by the investor. If the firm does not pay dividends, the investor can still get some cash by selling shares (a homemade dividend). If the firm does pay dividends, the investor can undo the dividend by using the proceeds received to buy additional shares. This theory may sound good on the surface, but things like transaction costs of a homemade dividend and the difference between the way dividends and capital gains are taxed make a homemade policy an imperfect substitute for the real thing.
• Dividends are better than capital gains. This theory is sometimes called the "bird-in-the-hand" theory. For those unfamiliar with the proverb, it goes "One bird in the hand is better than two in the bush." When hunting, because of the risk of not bagging a bird that is still in the bush, it’s better to have one in the hand rather than potentially two that might not ever make into your hand. As applied to dividends, the argument is that investors have a return "in the hand" with dividends; but if the company retains earnings the future returns are uncertain, so its better to get dividends since they resolve risk. Most finance people call this the bird-in-the-hand fallacy. If you want to resolve ALL of the risk involved with your stock investment, sell your shares at the known current price and put all of your money under your mattress! If some risk resolution is good, resolving all risk must be better yet. This position simply does not make sense, even though some investors (in particular those who rely on dividends for consumption) seem to behave as if it does.
• Capital gains are better than dividends. The argument here centers on the tax treatment of dividends vs. capital gains. Dividends are taxed as ordinary income, and tax liability is created whenever a firm pays the dividend, even in cases when investors sign up for the company’s dividend reinvestment plan (DRIP). Capital gains, on the other hand, are taxed at lower rates (depending on how long the asset was held) and are deferred until the investor actually sells shares. Since a dollar of capital gains results in more after-tax income to the stockholder than the same amount of dividends, the argument goes that stockholders are better off if the company pays no dividends and allows the stockholder to realize the tax-preferred capital gains when they want cash. It’s hard to argue with this theory. Certainly the tax differences should bias firms to favor capital gains over dividend income if they care about their stockholders. Still, there’s more to this dividend decision than the choice between dividend income and capital gains. Let’s try to improve our thinking.