Dividend Irrelevance Theory

What Is the Dividend Irrelevance Theory

Dividend irrelevance theory holds the belief that dividends don't have any effect on a company's stock price. A dividend is typically a cash payment made from a company's profits to its shareholders as a reward for investing in the company. The dividend irrelevance theory goes on to state that dividends can hurt a company's ability to be competitive in the long term since the money would be better off reinvested in the company to generate earnings.

Although there are companies that have likely opted to pay dividends instead of boosting their earnings, there are many critics of the dividend irrelevance theory who believe that dividends help a company's stock price to rise.

Understanding the Dividend Irrelevance Theory

The dividend irrelevance theory suggests that a company’s declaration and payment of dividends should have little to no impact on the stock price. If this theory holds true, it would mean that dividends do not add value to a company’s stock price.

The premise of the theory is that a company's ability to earn a profit and grow its business determines a company's market value and drives the stock price; not dividend payments. Those who believe in the dividend irrelevance theory argue that dividends don't offer any added benefit to investors and, in some cases, argue that dividend payments can hurt the company's financial health.

Dividends and the Stock Price

The dividend irrelevance theory holds that the markets perform efficiently so that any dividend payout will lead to a decline in the stock price by the amount of the dividend. In other words, if the stock price was $10, and a few days later, the company paid a dividend of $1, the stock would fall to $9 per share. As a result, holding the stock for the dividend achieves no gain since the stock price adjusts lower for the same amount of the payout.

However, studies show that stocks that pay dividends, like many established companies called blue-chip stocks, often increase in price by the amount of the dividend as the book closure date approaches. Although the stock can decline once the dividend has been paid, many dividend-seeking investors hold these stocks for the consistent dividends they offer, which creates an underlying level of demand.

Also, the stock price of a company is driven by more than the company's dividend policy. Analysts conduct valuation exercises to determine a stock’s intrinsic value. These often incorporate factors, such as dividend payments, along with financial performance, and qualitative measurements, including management quality, economic factors, and an understanding of the company’s position in the industry.

Dividends and a Company's Financial Health

The dividend irrelevance theory suggests that companies can hurt their financial wellbeing by issuing dividends, which is not an unprecedented occurrence.

Taking on Debt

Dividends could hurt a company if the company is taking on debt, in the form of issuing bonds to investors or borrowing from a bank's credit facility, to make their cash dividend payments.

Let's say that a company has made acquisitions in the past that have resulted in a significant amount of debt on its balance sheet. The debt-servicing costs or interest payments can be detrimental. Also, excessive debt can prevent companies from accessing more credit when they need it most. If the company has a hard-line stance of always paying dividends, proponents of the dividend irrelevance theory would argue that the company is hurting itself. Over several years, all of those dividend payouts could have gone to paying down debt. Less debt might lead to more favorable credit terms on the remaining outstanding debt, allowing the company to reduce its debt servicing costs.

Also, debt and dividend payments might prevent the company from making an acquisition that might help increase earnings in the long term. Of course, it's difficult to pinpoint as to whether dividend payments are the culprit of a company's underperformance. Mismanaging its debt, poor execution by management, and outside factors, such as slow economic growth, could all add to a company's difficulties. However, companies that don't pay dividends have more cash on hand to make acquisitions, invest in assets, and pay down debt with the money saved.

CAPEX Spending

If a company is not investing in its business through capital expenditures (CAPEX), there could be a decline in the company's valuation as earnings and competitiveness erode over time. Capital expenditures are large investments that companies make in their long-term financial health and can include purchases of buildings, technology, equipment, and acquisitions. Investors that buy dividend-paying stocks need to evaluate whether a management team is effectively balancing the payout of dividends and investing in its future.

Dividend Irrelevance Theory and Portfolio Strategies

Despite the dividend irrelevance theory, many investors focus on dividends when managing their portfolios. For example, a current income strategy seeks to identify investments that pay above-average distributions (i.e., dividends and interest payments). While relatively risk-averse overall, current income strategies can be included in a range of allocation decisions across a gradient of risk.

Strategies focused on income are usually appropriate for retirees or risk-averse investors. These income-seeking investors buy stocks in established companies that have the track record of consistently paying dividends and have a low risk of missing a dividend payment.

Blue-chip companies generally pay steady dividends. These are multinational firms that have been in operation for a number of years, including Coca-Cola, Disney, PepsiCo, Walmart, and McDonald’s. These companies are dominant leaders in their respective industries and have built highly reputable brands, surviving multiple downturns in the economy.

Also, dividends can help with portfolio strategies centered around the preservation of capital. If a portfolio suffers a loss from a decline in the stock market, the gains from dividends can help offset those losses, preserving an investor's hard-earned savings.