Is shareholder wealth impacted by changing a company's dividend policy?

As discussed in my previous blogs generally the sole guiding objective of a company is to maximise shareholder wealth - by changing a company's dividend policy will this impact shareholder wealth? A dividend policy is the strategy a company uses when determining the proportion of profits to be paid out to shareholders. Typically this is done twice a year with an interim and final year dividend however companies are under no obligation to do so. I have learned during lectures that there are many factors which need to be considered when determining a company’s dividend policy which I will discuss throughout this blog. Recently two oil companies - Eni and Statoil - made announcements surrounding their dividends providing a good opportunity to compare the impact this has had on each company. Eni, an Italian oil company, announced last week (13^th March) its plans to axe its spending following the oil price crash by cutting its dividend along with selling billions of dollars of assets (Financial Times, 2015). In contrast, Norwegian oil company Statoil did the opposite - announcing their intentions on 5^th February 2015 that they were “highly committed” to maintaining their dividend policy despite the difficult trading environment and competitors cutting their dividends (Bloomberg, 2015).

Will this change impact shareholder wealth?
 

No - says Miller and Modigliani (1961), referred to as M&M, who claim that dividends are irrelevant to a company’s value; instead this is determined by a company’s investment policy (Miller & Modigliani, 1961). Essentially they believe investment decisions are what determines a companies future earnings potential which is what impacts the share price and shareholder wealth. Therefore M&M argue that dividends represent a residual payment and should only be distributed if there is cash left over after investing in all possible projects with a positive NPV. Likewise if there is no cash left over, a dividend would not be paid and as a result, over the years, we would see highly fluctuating dividends. This suggests that companies should be focusing on their investment policy rather than spending time altering their dividend policy as it has no impact on shareholder wealth. 

Following M&M’s theory, when Eni announced they were cutting the dividend I would expect the company’s share price to remain relatively stable. However following the announcement of the dividend cut Eni's share price fell by 7% (Figure 1) which goes against M&M’s theory and suggests that a company’s dividend policy does impact value and shareholder wealth. CEO of Eni, Claudio Descalzi, stated that this decision was made with the aim of building a more robust company which will be capable of facing the challenging business environment with the lower oil prices. This implies that the company is focusing on long-term sustainable growth and hopefully wealth will be restored in the future as a result of this.

Figure 1: Eni Share Price (London Stock Exchange, 2015)

Looking at Statoil's share price this also goes against M&M's theory. Following their announcement to maintain their dividend policy their share price increased (Figure 2). Again this suggests that by altering the dividend policy it does impact value and shareholder wealth. 
 

Figure 2: Statoil Share Price (London Stock Exchange, 2015)

 

However, common to M&M’s theories, this theory was also based on a set of unrealistic assumptions. For example they assumed perfect capital markets where there is no transaction costs and no tax - which world do they live in?!

There are many theories and factors which oppose the views of M&M, including those listed below which will be discussed in more detail:

• Gordon's (1962) "bird in the hand argument"
• Clientele Effect
• Taxation
• Signalling

 

Gordon’s (1962) “bird in the hand” argument suggests that investors would prefer dividends now rather than company's retaining cash to allow possible, uncertain gains in the future (Gordon, 1962). This implies that because the future is unpredictable, investors would prefer a pay-out now rather than having it tied up in uncertain investments which may not provide a return. Given that Eni are cutting dividends to retain cash it could result in shareholders withdrawing from the company to seek alternative investments which are paying dividends. Consequently the share price would decrease leading to a reduction in shareholder wealth, thus suggesting that a companies dividend policy does in fact impact shareholder wealth.

Another theory opposing M&M's view is the clientele effect which suggests that shareholders are attracted to certain types of dividend policies (Jain & Chu, 2014) and therefore implies that a company’s dividend policy does affect value. For example pension companies seek constant, stable dividends and so whether an investor chooses to invest in a company is likely to be determined by the dividend policy and whether it suits their needs. This implies that companies need to understand the preferences of their shareholders in order to keep them happy, prevent them from selling their shares and to attract new investors. With Eni making the decision to cut their dividends, if shareholders require a stable income it may result in them selling their shares as it no longer meets their needs which will have a negative impact on value and shareholder wealth. It could be argued that the opposite will happen to Statoil. Given that they are maintaining their dividend it could suggest that they understand the needs of their investors. By announcing their dividend intentions it will reassure investors as they know it will continue to meet their preferences but may also attract new investor’s seeking a stable dividend thus increasing shareholder wealth.

Clientele theory is reinforced by taxation (bearing in mind that M&M assumed no taxes) as investors who are subject to paying lower tax prefer dividends whereas those subject to higher tax prefer lower dividends or capital gains (Jain & Chu, 2014). This further suggests that certain investors are attracted to particular companies depending on their dividend policy and reinforces that changing the policy could decrease shareholder wealth. Therefore companies must carefully consider the affects which changing their dividend policy could have.

Another factor which suggests a company's dividend policy affects shareholder wealth is the concept of signalling. Signalling gives investors an idea about the expected future performance of a company (Karpavičius, 2014). This is based around the idea of information asymmetry as investors don’t have access to internal information and so depending on a company’s decision regarding dividend pay-outs it can signal to investors how well the company is expected to perform in the future. For example, if high dividends are paid this signals good news to the market that the company is optimistic about the future which is likely to see an increase in the company's share price. Likewise if lower dividends are paid, or cut as in Eni's case, it suggests the company may be struggling and are concerned about the future performance of the company. Therefore dividends can be seen as an information transferring mechanism from inside a company to the market place. With Eni announcing the dividend cut, this theory suggests that the company may be concerned about the future due to the current difficult trading environment as a result of the oil price crash. Following the announcement the share price dropped. In contrast, by maintaining their dividend Statoil are signalling to investors that they are optimistic about the future, this was met with an increased share price. The concept of signalling clearly suggests that dividends are significant determinants of a company’s share price and therefore a company's policy does impact shareholder wealth.

 
To conclude, whilst I agree with M&M's theory that a company's investment decisions are essential to a company's profitability, as demonstrated with Eni and Statoil, I believe that a company’s dividend policy does have a significant impact on a company’s share value and therefore does affect shareholder wealth. Whilst there is no obvious way for a company to determine their policy I believe this is something that will be established over time and as discussed throughout this blog there are many factors which a company must consider when making decisions in relation to dividends. For example they should understand the preferences of their current shareholders and consider how they will react to significant changes in dividends. Personally, I think company's should aim to have a stable dividend policy with consistent pay-outs and stable growth as I believe this will retain investors as well as attracting new ones.

 

References

Bloomberg (2015). Statoil CEO Says `Highly Committed' to Dividend Policy. Retrieved 16^th March 2015, from http://www.bloomberg.com/news/videos/2015-02-06/statoil-ceo-says-highly-committed-to-dividend-policy

London Stock Exchange (2015). ENI. Retrieved 16th March 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/international-markets/indices/company-summary.html?symbol=ENI&market=MTA

London Stock Exchange (2015). STATOIL ASA STATOIL ORD SHS. Retrieved 16th March 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=NO0010096985NONOKEQS

Financial Times (2015). Eni to cut dividend and suspend share buyback. Retrieved 16^th March 2015, from http://www.ft.com/cms/s/0/c6ff2624-c994-11e4-b2ef-00144feab7de.html#axzz3UXyAnaFA

Gordon, M. J. (1962). The savings investment and valuation of a corporation. The Review of Economics and Statistics, 44(1), 37-51. Retrieved from http://www.jstor.org/

Jain, P. & Chu, Q. C. (2014). Dividend clienteles: A global investigation. Review of Quantitative Finance and Accounting, 42(3), 509-534. doi:10.1007/s11156-013-0351-2

Karpavičius, S. (2014). Dividends: Relevance, rigidity, and signaling. The Journal of Corporate Finance, 25, 289-312. doi:10.1016/j.jcorpfin.2013.12.014 

Miller, M. H. & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433. doi:10.1086/294442