When Do Dividends Really Matter?

They have a positive effect on valuation during a financial crisis and a negative one when markets are booming.

Throughout the financial crisis, there have been substantially fewer dividend increases and an abnormally large number of dividend cuts. These generally stingy dividend policies were often in response to a true liquidity crunch. But for many, dividend prudence merely reflected general conservatism. As economic fears subside, many CFOs are evaluating whether reinstating or boosting dividends would help their share price.

The decision is difficult in the face of an abundance of divergent views. In his paper “Do Dividends Really Matter?,” the renowned Nobel Laureate Merton Miller argued that “the seeming evidence that dividends do matter. . . is not to be trusted. It’s an optical illusion.” He claimed the apparent effect of dividends on share prices is not caused by the dividends per se, but is merely the market’s recognition of what the dividends communicate about investment policy and future earnings trends. Given this, it would seem an open-and-shut case that dividends don’t matter.

Then why the fuss? One main reason is that many investors pester management by demanding new or increasing dividends. Those investors cite studies showing that dividend payers are better than nondividend payers at delivering total shareholder return (TSR), which reflects a company’s stock-price change plus the dividends paid during a period. A flurry of such recent studies has attracted attention by the press and in the boardroom. What should a CFO do?

It depends. Our capital-market research on the dividend policies of the 1,000 largest nonfinancial companies, excluding those that were not public for the full decade of the 2000s, indicates there is no one-size-fits-all answer.

Our research shows that dividends have a positive effect on valuation during a financial crisis and a negative effect when markets are booming. When economic confidence is low, investors fear the worst and prefer the cash in hand. In boom times, however, there is more confidence that companies will invest wisely.

Milano 4-1-11

To determine this, we measured corporations in terms of enterprise value to gross operating assets and compared that to the cash-on-cash return on capital. There is a strong correlation between those measures of valuation and return, as documented in “Postmodern Corporate Finance” in the spring 2010 Journal of Applied Corporate Finance.

Some companies are valued higher or lower than their returns alone would imply. We tested to find if dividends influenced those premiums or discounts. From 2004 through 2007, a majority of companies trading at a premium were nondividend payers. This flipped in the first quarter of 2008, and from then until today a majority of companies trading at a premium are dividend payers. The gap is closing and seems to be reversing.

This cyclical dividend influence partly explains why recent share-price performance has been better for dividend payers. Dividends went from reducing valuation to increasing valuation, benefiting the capital gains of dividend payers. Depending on the forward trend in the economy and stock market, this may flip again — meaning that this may not be the best time to initiate a dividend.


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