Dividends: The Reward to Shareholders
From the retail investors to commercial banks, dividends are an important part of financial markets. These payments to shareholders, often dubbed as ‘rewards’, are not only a topic of debate between financial managers but are also an important component of equity valuation. This article will investigate the reasons for and against dividends, whilst also delving deep into the current state of the dividend market and the famous Dividend Growth Model.
What Are They?
A fundamental part of the stock market, a dividend is a share of profits and retained earnings that a company pays out to shareholders, usually quarterly. Dividends are issued on a per-share basis meaning that for every share owned, a set amount will be paid to the owners of said share. They are most commonly issued in the form of cash or stocks wherein instead of a monetary payment, the payment is made in the form of additional shares. One-off dividends (known as Special Dividends) may also occur but are rarer and are as a consequence of better than expected performance or supplementary cash within a company.
An important term to note is Dividend Yield. The yield of a dividend is the percentage of the share value that is being paid out to shareholders, calculated by dividing the dividend issued per share by the current share price. Generally, the higher the yield the better although it is important to evaluate whether the company offering the high yield is also reinvesting in themselves.
A Brief History
The first recorded dividend was issued by the East India Company for almost 200 years in the 17th and 18th centuries, at a yield of around 18%. [1] In the 19th and 20th centuries, yields averaged around 5% but market sentiment changed in the 1980s. With the perception of risk disappearing along with the bear market, investors looked at equity less as an income stream, and more of a way to appreciate the value of their money and with that went dividend yields. However, the Tech Crash of 2000 and the Financial Crisis of 2008 pushed risk back again to the forefront of investors’ minds. Record dividend payments of £110.5bn in 2019 show more of a focus on rewarding shareholders in this way. [2] [3]
COVID-19’s Impact
Like with most of the financial world, the COVID-19 pandemic has had grave consequences on the profits of many firms, impacting the payment of dividend. Companies such as Shell have cut their dividend for the first time since World War Two as a result of a 46% fall in net income in Q1 of 2020.[4] Telecommunications company BT have also felt the brunt of the pandemic, suspending their annual dividend for the first time in 36 years – a clear signal of financial worry. [5]Findings suggest although they are rarer, dividend bear markets last longer than bearish stock markets, spelling worry for dividend investors looking for returns on their investments any time soon. [6]
The Dividend Aristocrats
Though the recent history of dividends points towards a slowdown of such payments, there are some firms that have kept up payments to shareholders for extensive periods of time. The term ‘Dividend Aristocrat’ refers to a list of companies within the S&P 500 (an equity index of some of America’s largest companies) who have paid and increased their base dividend every year for at least 25 consecutive years. Typically, the companies listed, which totalled 66 in July 2020, are proven companies in their sector with great financial management and reliable income. The likes of Coca Cola and Johnson & Johnson sit at the top of the list having increased and paid dividends for 57 years making them very attractive to dividend investors. [7]
Why Give Out Dividends?
A common topic of debate in financial management is whether or not a company should issue dividends. Sceptics would argue that if investors want a steady stream of payments, they should invest in bonds. Additionally, many companies view their profits and retained earnings as a way to finance future growth which, in the long term, would increase the value of the company’s shares to the benefit of the shareholder. Elon Musk’s Tesla is a notorious company in favour of financing future growth as oppose to issuing dividends, who ‘do not anticipate paying any cash dividends in the foreseeable future’. [8]
The main argument in favour of paying dividends is that it provides certainty of a company’s financial health and stability within a company. This incentivises long-term investment so investors can reap the rewards of the dividend payments. The investment enables the company to fund new projects and thus fulfil the goal to grow as a business.
The Dividend Growth Model
Whilst there is much debate about dividends themselves, them being issued by a company holds great importance for investors and financial strategists who look to incorporate these payments into equity valuations. The Dividend Growth Model is a piece of financial analysis used daily to work out what equities to buy and sell to optimize portfolio returns. This is done by estimating the fair value per share of equity, comparing it to the current share price and then evaluating whether the equity is undervalued or overvalued. The model is as follows:
P = D1/(k-g)
Where:
P = the fair value per share of equity
D1 = the dividend paid
k = the required rate of return (the minimum return investors require to buy the equity)
g = expected dividend growth rate
The reality of the Dividend Growth Model is that it is simple, meaning that whilst it can be a fast way to get indications of an equity’s value it does have some shortcomings. Firstly, the model assumes a constant growth of dividends for an extensive time period which, in reality, can be difficult to predict. This means that the calculations must be frequently repeated to ensure accuracy. Furthermore, the model does not take into account pivotal parts of a share’s value such as brand loyalty or ownership of intangible assets (patents, trademarks, copyrights etc.) which increase the value of shares. Finally, there is no regard for market conditions which undoubtedly would have a significant impact on share value.
Whilst its shortcomings are prevalent, it is the simplicity of the model which makes it so useful to investors. Like all pieces of financial analysis, the model should not be used in isolation and should rather be utilised in combination with various other valuation techniques, leading to a more accurate final calculation. Overall, the model goes to show the importance of dividends in the daily equity valuations that occur across the financial world.
In summary, Dividends are a pivotal part of the global equity markets for all investors. Whilst there are many cynics, dividends will remain an integral part of the financial markets for firms wanting to boast financial health and attract long-term investment. Meanwhile it will be interesting to see if the COVID-19 pandemic continues to affect dividend payments, or will firms return to the ‘shareholder friendly’ years of recent history.