Stock Valuation

Valuations rely heavily on the expected growth rate of a company; the past growth rate of sales and income provide insight into future growth. A no-growth company would be expected to return high dividends under traditional finance theory. Ideally, the portion of the earnings not paid to investors is left for investment to provide for future earnings growth. By the end of this section, you will be able to explain how a stock is valued and describe the limitations of valuing a company with dividends that have a non-constant growth rate.

Expected Dividends, No Growth

A no-growth company would be expected to return high dividends under traditional finance theory.


LEARNING OBJECTIVE

  • Describe how a company should make a dividend decision when it expect no growth

KEY POINTS

    • Companies generally either retain earnings for investment, or distribute them as dividend, according to their growth strategy.
    • Clientele effects suggests that different dividend levels attract different types of investors.
    • Value investors look for indications that a stock is undervalued. High dividends are one indication of undervaluation.
    • Knowing a firm's cost of capital is needed in order to make better decisions. Managers make capital budgeting decisions while capital providers make decisions about lending and investment.

TERM

  • clientele

    The body or class of people who frequent an establishment or purchase a service, especially when considered as forming a more-or-less homogeneous group of clients in terms of values or habits.


The Dividend Decision

Whether to issue dividends and what amount is calculated mainly on the basis of the company's unappropriated profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash flows, which means cash remaining after all business expenses, and capital investment needs have been met.

If there are no favorable investment opportunities–projects where return exceed the hurdle rate–finance theory suggests that management will return excess cash to shareholders as dividends. However, there are exceptions. For example, shareholders of a "growth stock," expect that the company will, almost by definition, retain earnings so as to fund growth internally.

At the other end of the spectrum, investors of a "no growth," or value stock will expect the firm to retain little cash for investment, and to distribute a comparatively greater proportion to investors as a dividend.


Clientele Effects

This suggests that a particular pattern of dividend payments may suit one type of stock holder more than another; this is sometimes called the "clientele effect". A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.


Value Investors

No growth, high dividend stocks may appeal to value investors. Value investing involves buying securities with shares that appear under priced by some form of fundamental analysis. As examples, such securities may be stock in public companies that have high dividend yields, low price-to-earning multiples, or have low price-to-book ratios. Thus, high dividends and low reinvestment of retained earnings can signal an appealing value stock to an investor.


Investing Trade-offs: Value investors trade growth for dividends.

Source: Boundless
Creative Commons License This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.