The Dividend Puzzle – Retention vs. Distribution

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Introduction and background details

Dividend

The dividend is a taxable payment declared by the company’s board of directors and is distributed among its shareholders. This distribution is out of the company’s earning or retained profit. Dividends could only be paid from the amount of profit that the company has made and could not be distributed from the company’s equity or capital amount. Dividends also need to be and must be in the shape of a real asset. (Peter, p. 24, 1998) Dividends are mostly paid in cash however the other way of making this payment is through stock known as a stock dividend or the other way is through the property. Dividends are paid to their shareholders in accordance with the number of their holdings in the company that is it is shared on the basis of your investment in the firm. (Johannes, p. 62, 1976).

It is not mandatory for a company to be involved in a process of paying dividends but this dividend is paid by companies that have gone beyond their way of growth and have progressed. These companies no longer could benefit enough by reinvesting their company’s profit into the capital. Such companies usually decide to pay out their earnings to their shareholders. This process is called dividend payout. (B. Douglas, p. 24, 1991).

Retained earnings

Retained earnings are the net income of an organization that is being retained by the organization rather than being paid to the shareholders in the form of dividends. These retained earnings are being used by the organization as capital again to reinvest in the business or to pay debts of the creditors of the company. (Ricardo, p. 60, 2003)

Dividend puzzle

The study of the Dividend puzzle is vital in the field of finance as well as in economics and academics. It is a concept in which the companies pay their retained earnings in the form of a dividend to their investors. However, the investor already owns the company and should not have any problem with whether the payout is distributed or reinvested in the company’s capital. (Maria, p. 40, 1991).

Why a puzzle?

As the dividend that a firm gives to its investors represents a certain return that the investors would be getting for their investment with the company. Dividends are paid by the companies to encourage the investment of their shareholders and to attract the new market of investors to invest in their company and buy its shares at a higher rate. The payout of dividends encourages investors as they get a chance of getting rewarded by the dividend or they can sell their shares at a higher rate in the future. So, investors pay more attention to the companies that pay dividends. Such companies are termed under the category of “Dividend Distribution”. (Allen, p. 15, 2000)

However, it is also termed the other way around. A company that reinvests its retained earning and does not pay out a dividend at all shows that they have more opportunities for investment and have the capability of growing higher and higher through this measure of reinvesting their earnings. This shows the company’s confidence towards its growth and thus attracts more investors to invest in the company’s capital. (Harold, p. 20, 2005) These companies show the courage of reinvesting and thus build the image that through reinvesting they would be able to make more earnings and would bring the price of their shares higher than they could have paid a dividend to their investors. So, the investors pay more attention to the companies that reinvest and are satisfied with capital appreciation. Also, another area of interest for them is that there is lower taxation on capital appreciation than on dividends. Such companies are termed under the category of “Dividend Retention”. (Ricardo, p. 62, 2003).

This creates confusion and makes the puzzle harder to solve as both the aspects are two different shores of the same sea that could not join hands together.

Historical background of the dividend theory

The Dividend theory has emerged way back in the sixteenth century and has been carried forward to the modern era of economics and finance. A relatively large number of theories have been proposed since then and have been defined as a number of factors that influence the process of distribution and retention of dividend/earnings. (Ricardo, p. 64, 2003)

Initially, there have been small companies but then with the passage of time, the companies enormously increased in size and capital, and there arise the questions of how to distribute the payouts and how much to distribute. (George, p. 11, 2003).

Then from the seventeenth to the nineteenth century, the era evolved where companies used the dividends as the source of encouraging the investment and the shareholders. (P Weil, p. 3, 1989) The dividends were used to increase the price of shares and attract the new capital market to invest in the company. (George, p. 12, 2003).

Also, in the current time, various studies and theories have been evolved to explain the phenomena of distribution and retention. (George, p. 12, 2003).

The Miller-Modigliani theorem

The Miller-Modigliani theorem explains that there is no difference being faced by the investor whether if the company is paying a dividend or reinvesting the amount in the capital because of the fact that if the company pays a dividend to the stockholder the amount paid as a dividend would reflect an immediate equivalent effect or drop in the whole range of the possible increase in the stock price by that amount if and only if ignoring the transactions costs, taxes and other influencing factors. Therefore, the choice between a company’s shares that pay out their earnings and that of the company that retains the earning is quite similar excluding all the influencing factors. (Luis, p. 13, 2004)..

According to this theorem the higher, the investor gets a dividend of its shares the lower capital appreciation he would receive, and likewise the if no dividend is paid out the higher the capital appreciation he would receive from the company. (Luis, p. 14, 2004).

Also, it does not affect the company’s business decisions as the issuing of securities by the company would increase the amount of cash while paying out the dividend would reduce the amount of cash being held by the company. (Luis, p. 14, 2004).

Factors influencing the dividend puzzle

The factors that influence the payment of dividends include the following:

Firm’s characteristics

According to a number of writers, the payment of the dividend is associated mostly with the characteristics of the firm.

Out of the characteristics of the firms that influence the dividend most significant are given below.

The size of the firm.
The profitability earned by the company. (Robert, p. 50, 2009).
Growth opportunities of the company.
Company’s maturity.
Institutional stock holdings.
Regulation.
Incentive compensation.

Market’s characteristics

Taxes: The most significant of all is the taxes. The payment of dividends also is affected by the amount of taxes involved. As there exists higher taxation on the dividend the investor finds it more feasible that the company does not pay the dividend but reinvest the earning. The taxation on capital appreciation is relatively lower than in the case of dividends. (Robert, p. 51, 2009)
Investor Protection Law: The laws under which company regulate and decide on the payment of dividend. This varies from region to region and state of law is main driving factor. The two main factors under the Investor’s protection law include:

The ownership rights of the shareholders.
The control rights of the shareholders.

The dividend rates also vary depending upon how the company and the region emphasize these laws to be followed. The companies that have a higher influence of these laws have higher dividend rates while those having low will be having lower rates of dividends. (Robert, p. 51, 2009).

Investor’s sentiment: The demand for dividends depends upon the investor’s demands. So more if the investors start investing in the companies paying a dividend, the market would penetrate and move towards paying a dividend. Also, the premium would be paid in accordance with what rate is prevailing in the market. (Robert, p. 51, 2009).
Public versus private status: Comparing the policies of publicly held firms and the privately held firms gives us identification and realization of forces that affect the payment of dividends. The evidence has proved that conflicts of interest between controlling and minority shareholders tend to reduce the dividend payment in many private firms. However, the governance mechanism leads to higher dividends in public firms. (Robert, p. 52, 2009).
Characteristics of newly listed public companies.
Product Market Competition: The competition in the market is another most significant characteristic of the decision to be taken whether to make the dividend payment or to retain the company’s earnings. In various studies, it was found out that the company’s facing immense market competition tends to payout dividends than reinvest because if they do not pay the dividends the disciplinary forces of competition would hold the company penalized. However, the companies where competition is relatively low, the management takes the opportunity to bring in a sign of good reputation and use dividends as a substitute for competition. (Robert, p. 53, 2009).

The studies reflect that the companies that are in a less competitive environment have fewer ratios of dividend payouts than the ones in a more competitive environment.

Substitute forms of payout

VALUE OF FIRMS THAT DO NOT PAY DIVIDEND: Through the Miller Modigliani theorem, people would be thinking that if the company is not paying a dividend then it is of no worth. This assumption is not true having the fact that if the company is not paying dividends there are other ways through which investors could take out cash and would benefit from this non-payment of dividends. (Robert, p. 54, 2009). Some of the ways include the following:

If a company is not paying the dividend of its earnings then the investor would not be taxed a high amount as the tax paid of dividend is much higher than that on the capital appreciation.
Also, the investor if of a closely held company then could be given a job at a much higher salary in the company.
Also, the investor could order goods or products of other companies of which he is also a shareholder. The investor could earn by ordering those products at a higher price.

So, these other methods enable a company or firm to be of more value to its investors although if it is not paying any kind of dividend to him. (Robert, p. 54, 2009).

Changes in dividends and their effects

The managers of corporations say many a thing about their company’s growth, profitability, productivity, and reputation through their policies and rates of paying a dividend. The managers when feeling that the company is going well and would enhance the profitability much higher in the near future. The managers increase the dividend in order to attract more customers and to publicize the profitability and growth of its company. (WG Christie, p. 3, 1990).

No companies would wish to decrease their dividend as it would discourage the investor but need to do so when it feels a possibility of poor recovery from the capital invested in the company. When the managers of the company are expecting lower returns, they tend to decrease the dividend rate. (HK Baker, p. 1, 2002).

All of this information is conveyed to the investor through the company’s dividend policy. The decrease in the company’s dividend rate also decreases its market reputation and goodwill and in turn decreases the stock price of the company’s shares. The increase however in the dividend rate enhances the market reputation and the share price. (WG Christie, p. 3, 1990).

If these forecasts of the company’s return exhibit a true or even worse picture of the company’s return then the stock price drop would be permanent. However, if the drop-in price is not due to the forecast the change would be temporary. (GM Frankfurter, p. 4, 1999).

Dividend retained as capital

One of the lowest-cost sources that could be brought in availability to the company’s capital would there be the amount that is paid as a dividend. If a company retains the amount that it could have paid to its investors as a dividend or their share the company does not need to look out towards the financial market and creditors for the amount required for the company’s basic functions and operations. (SC Mayers, p. 4, 1984).

The amount of capital that is raised by cutting the dividend payments is the least cost as it is the company’s own amount that is reinvested. However, when compared to the amount of cash or capital taken from the market the company then needs to make its payment with the amount of interest and any other service charges being agreed upon the amount that is financed from the creditor. (GE Powell, p. 1, 1999). Cutting the dividend payment thus remains the lowest cost method of raising money for the company. (KR French, p. 3, 2001).

Current issues

Companies that have never and would never pay dividends

There are companies that have never ever paid dividends throughout their history such as DELL, EasyJet, etc. Dell and other companies that do not pay dividends realize the true value of the investment. They claim that the money that is reinvested in buying back shares of the company is worth more than that dividend which is paid and is kept under the pockets or bank accounts of the shareholders. The money that is reinvested is much more profitable and shows that the company has confidence in itself. It also shows that the company has brighter plans for investment and growth. EasyJet has never paid any kind of dividends in its history of the last eighty years. Buying back of shares increase the demand of the shares and eventually result in a high price of the share. (Danial, p. 1, 2009).

Intel is also another good example. The results of buying back in Intel are transparent. The company buys back a comparatively large number than it pays in dividends. However, the company does pay a dividend but it is a relatively very small amount as compared to the reinvestment, for example, the company reinvests each year about 4-5 billion however it pays a dividend of only about 530 Million a year. (Danial, p. 1, 2009).

Economic analysis and various studies have explained that the option of buying back the shares is good for the company as well as its shareholders. (Danial, p. 1, 2009).

Companies that have cut down or have stopped paying dividends

Nowadays the market because of the recession and economic crisis companies have now either lowered down the amount or rate of dividends or have stopped paying the dividend. As the yield or per capita income has decreased or lowered down by a considerable amount the payment of dividends would make the company face more and more crises and downturns. (Tom, p.1, 2009)

Most significant companies that have dropped down their dividend payment rate due to the global economic crisis that is shaping our financial conditions into a new fold include Wells Fargo & Co., Macy’s Inc. etc.

Due to this cash flow many companies are cutting their dividends and are compelled to do so as the recession affects the companies worldwide across the globe. (Tom, p.1, 2009).

Conclusion

All the studies and theories that have been defined in the study of The Dividend Puzzle reflect that this puzzle remains unsolved and the search for its explanation continues and as stated by (Black, 1976) we must admit that “The harder we look at the dividend picture the more it seems like a puzzle with pieces that just don’t fit together.” (Black, p. 64, 1976).

This puzzle remains the topmost significant theory of economics and finance that is unsolved for more than half a century. However various studies throughout have identified that under perfect capital markets, the payment of dividends to the stockholders does not affect the price per stock. But when the market is imperfect and there are various factors that influence the capital market then the payment of the dividend does have an impact on the price of the stock. There the company requires setting a dividend policy to carefully assess the firm’s characteristics, market competition, and other substitute forms of dividend beforehand. Thus, a careful assessment of all the influencing factors could result in a more favorable move for the company which could be either paying through a dividend or providing the investor with capital appreciation.

References

Allen F, “A Theory of Dividends Based on Tax Clientele”, 2000, (Published by The Journal of Finance)
B. Douglas Bernheim, Tax Policy and the Dividend Puzzle, 1991, (Published by The RAND Corporation)
Black Fischer, The Dividend Puzzle, 1976, (Published by Journal of Portfolio Management)
Danial Gross, Why cash-rich companies like Dell and Microsoft don’t (and won’t) pay dividends, 2009, (Published by Newsweek Interactive Co.)
George M. Frankfurter, “Dividend policy: theory and practice”, 2003, (Published by The Academic Press)
GE Powell, Quarterly Journal of Business and Economics, 1999, (Published by questia.com)
GM Frankfurter, Journal of Investing, 1999, (Published by The CFA Institute)
Harold Kent Baker, Understanding financial management: a practical guide, 2005, (Published by Wiley-Blackwell)
HK Baker, Review of Financial Economics, 2002, (Published by The Ideas Repel Organization)
Johannes Raaballe, A Piece to the Dividend Puzzle, 2002 (Published by The Empirical Rationale)
KR French, Journal of Financial economics, 2001, (Published by The Elsevier)
Luis Correia Da Silva, “Dividend policy and corporate governance”, 2004, (Published by The Oxford University Press)
Maria Rosa Borges, Is the Dividend Puzzle solved, 1991, (Published by Technical University of Lisbon)
P Weil, Harvard Institute of Economic Research, 1989, (Published by The Delong)
Peter L. Bernstein, Streetwise: the best of the Journal of portfolio management, 1998 (Published by Princeton University Press)
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Robert W. Kolb, Dividends and Dividend Policy, 2009, (Published by John Wiley and Sons)
SC Myers, Journal of finance, 1984, (Published by The JSTOR Organization)
Tom Petruno, Dividends cuts outnumber increases, 2009, (Published by The KTLA)
WG Christie, Journal of Financial Economics, 1990, (Published by The Ideas Repel Organization)