Theory doesn’t always align with reality...which is why we call theories “theories.” That’s the case for dividend irrelevance theory fo sho.
Dividend irrelevance theory says that, in theory, a company’s dividend policy shouldn’t affect a company’s stock price/value at all, since investors can respond to what’s happening with dividends (going up or down) accordingly. These two guys argued that shareholders aren’t, like, “locked in.” For instance, if dividends go up, investors can just reinvest that money, and if dividends go down, investors can just sell some of their shares, using that money elsewhere to get the money they planned on getting from the dividend.
Basically, they argue that dividends don’t add value, because investors can put that money elsewhere...where it’d also be making money.
Yet, there have been a lot of super-academic studies on this, and they show that dividends do indeed increase the price of stocks, especially for high-end blue chip stocks. So...it seems like dividends are perceived by investors as icing on top, even though they could get their icing elsewhere with that same money...in theory.
Related or Semi-related Video
Finance: What is the Dividend Discount M...2 Views
Finance allah shmoop what is the dividend discount model Well
it's a technique used to value companies or at least
it wass in the stone age And yet in the
nineteen fifties maybe which basically says that a company's value
is fully contained in the cash dividends it distributes back
to invest doors This model is only useful really for
its historical relevance We we just don't use that much
these days Yeah back in the old timey cave man
days when there was essentially no research of real merit
being done on the performance of investments of whatever flavor
the dividend discount model was the best thing investors had
to value an investment in a company And remember in
those days companies paid rial dividends that were a meaningful
percentage of the total value of the company Unless so
a company pays a dollar a share this year in
dividends Historically it's raised dividends at about three percent a
year like paid a dollar last you'd expect two dollars
three next year in dollars six and change the next
so well The dividend discount model discounts backto present value
And yes we have an opus on what president value
Means but here's the logline definition present value of all
future cash flows discounted for risk in time Back to
cars Yeah that thing well a few odd things are
worth noting in this horse and buggy era formula The
dividend discount model ignores the terminal or end value of
the company Like say twenty years from now the company
is sold for cash The dividends are all that are
really focused on though in our model that seem strange
to you Well maybe But let's say the discount rate
is ten percent in the risk free rate is four
percent for a total of fourteen percent a year discounted
back to the present So doing the math just looking
at the terminal value of say a hundred million bucks
in a sale to be made twenty years from now
Let's figure out what that's worth today Well you take
the one point one four Put it to the twentieth
power to reflect twenty years of discounted valuation compounding And
you say one point one four forty twenty powers about
thirteen point seven So to get the present value of
one hundred million bucks twenty years from now using this
discount rate Will you divide the hundred million by thirteen
point seven and that means that the one hundred million
dollars twenty years from now today is worth only seven
point three million bucks And yeah that's ah big haircut
kind of like this guy Well the formula focuses ah
lot on near term dividend distribution and it's Really more
interesting is a relic of original financial research in theory
than anything directly useful today And if you find this
interesting while then we may have a gig for you
here at shmoop finance central Yeah come on down We 00:02:39.715 --> [endTime] need writers good ones not like me
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