Are Dividend's really relevant?

A dividend is a sum of money that comes from excess earnings, which a company pays their shareholders annually through two different payments, these being; the Interim payment, which comes after their interim results are published and a Final payment, which comes after the year has ended. Whilst it is not a legal requirement for companies to pay dividends, a lot of companies will make the choice to pay them in order to keep their shareholders interested. However, a company does have the ability to lower their dividend at any time, which can often be linked to a company’s level of investment, for example; when a company decides to invest, the first question that will be asked is; how will we finance this investment? Which is the exact same question that is asked when a company decides to offer a dividend to shareholders. As a result of this, due to shareholder power, companies will tend to offer a higher dividend which in turn means that there will be a lower amount of investment from said company.

Recently breakdown cover provider AA made the decision to lower their dividend from 9 pence to 2 pence in order to invest $54 million into the development of new services. Following this announcement AA had a 28% fall in shares and predicted that their profits for next year will be between £335 million and £345 million, significantly lower than their original predictions of around £390-£395 million. In the eyes of a shareholder, a 7 pence decrease in dividend is quite an extreme dip and I can definitely see why shares would fall such a large amount. However, this level of investment from AA could be seen as a good thing, as it means they are looking towards the future and have a focus on long term value creation. Nevertheless, it is not all bad news for AA, as not all of their shareholders will just be there for the dividend payments and will be looking at the bigger picture of whether or not AA is looking to maximise shareholder wealth.

When it comes to the maximisation of shareholder wealth there is an academic debate on the relevance of Dividend’s. The first side of the debate comes from Modigliani and Miller (1961) who argue that, from an investors point of view, they are not looking at the amount of dividends paid now, but at what the companies earning potential is for the future, therefore with AA’s decision to invest excess capital into the development of new services, in Modigliani and Miller’s eyes they are still likely to attract shareholders, as this investment will greatly increase future profits. However, due to Modigliani and Miller’s argument stemming from the theory of a perfect capital market, the  opposing side of the debate is more focused on an imperfect capital market with Lintner (1956) and Gordon (1959; 1963) suggesting the “Bird-in-the-hand-theory”, which makes the argument that shareholders will find the option of dividends preferable due to any uncertainty when it comes to how much money they can gain in the future. In terms of AA, from their choice to lower their dividend they will in turn effect their market value as their shareholders may make the decision to sell their AA shares and buy shares from another company. Hypothetically, as a result of this their share price would drop, which is exactly what happened, as previous to their announcement their share price was at 116.30 pence and post announcement it dropped by 32.72p to 83.58 pence.

In my opinion this isn’t something that AA should really focus on, as any shareholder that is invested in them with the sole purpose of gaining dividends isn’t looking towards the future and does not have any care for business growth. However, there are a few cases in which long term growth isn’t really the main priority of a shareholder, for example any shareholder of AA that is elderly with no steady income, may want instant gratification and will look for a dividend as a definite payment that they can receive twice a year. In this case I can understand why some shareholders focus on dividend’s, as the future growth of AA is something that will not benefit them in the short term, therefore meaning this is something that the board of directors at AA should take into consideration when looking at their nearly 30% drop in shares.

In practice companies will tend to lean towards the outlook that Dividends are relevant and will attach a certain level of importance to what amount their Dividend is at. This is due to them having the mindset that having a dividend that is too low will mean investors will lack confidence in the company, whereas setting a dividend too high is not sustainable in terms of growth. As a result of this the company will try and set a ‘stable’ dividend that is just right. However, one question I would ask in relation to a ‘stable’ dividend is; how can a company be certain that they have the ability to pay a set amount every year? Because surely any excess earnings will differ from year to year.

Overall, I think that AA is making the right choice as the main focus of a company is to be able to grow and from what I have learn in my university lectures, without internal investment into the company there is no possibility for that. Although their decision to lower dividend has had an adverse effect on shares now, any shareholder that will have the right mindset will know that this is the best decision for AA in the long term.

Gordon, M. (1959). Dividends, earnings, and stock prices. Review of Economics and Statistics, 41(2), 99-105.

Gordon, M. (1963). Optimal investment and financing policy. Journal of Finance, 18(2), 264-272.

Lintner, J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes. The American Economic Review, 46(2), 97-113.

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