Both of these outlets have very fair justifications; a company
needs to continue to invest in its operations to innovate or expand in its
marketplace and ultimately improve its competitiveness, whereas shareholders
are an integral aspect of an organisation’s funding and essentially are
‘owners’ and therefore deserve a return for their investments. The underlying
issue for most businesses, however, is to adopt a policy which strikes an
optimum balance between these options – if one even exists. This issue exists
because organisations fear a dividend policy which does not reflect the
expectations of its shareholders can prove detrimental to the company’s share
price, and consequently, value.
Modigliani and Millar (1961) first noted that share prices
were determined by future earning potential and not dividends paid “now”. They
proposed a rational investor, an
investor who is indifferent to capital gains and dividends. However, this study was based on idealistic scenario
conditions where there are no taxes, no transaction costs, all interest rates
are the same and all investors have free access to all relevant information (Brennan, 1971).
These are clearly scenarios which modern day managers cannot operate within and
are therefore irrelevant towards their dividend policy, which leads me to agree with Watts' (1973) proposal that dividend payments are most definitely an indicator of company performance.
Furthermore, I am slightly sceptical that stock markets are
entirely filled “rational” investors. Although, I do acknowledge an abundance
of highly-trained and qualified fund managers make up a significant portion of
stock market trade, the markets can still potentially be influenced by everyday
stock traders looking for a “quick buck” and who are overly anxious to shift
their investment decisions at the slightest hint of uncertainty or hunch.
It is in human nature to fear uncertainty and even
businesses need to conform to the vulnerabilities of human psychology. Market
uncertainty can become apparent when investors are unsure of their company’s future
operations.
Consider the following discussion:
Company A discovers a novel project
which could substantially improve its competitive sustainability and provide an
attractive NPV. The company must utilise its cash deposit to undertake this
investment before it direct competitors gain first-mover advantage.
Consequently, Company A lowers its
dividend pay-out to provide additional investment funding but keeps the
reasoning for this manoeuvre confidential so competitors are not exposed to the
exclusive information.
Perhaps this news is not revealed because companies do not
want to disclose too much of their strategic intentions as competitors will
become aware; therefore, the longer they can keep project information
confidential, the more effective and successful their strategy will be,
possibly achieving greater NPVs on projects. This is a hypothetical scenario,
but a feasible one which could subsequently lead to lowering share price, thus
undervaluing of a company, simply as a result of shareholders feeling uncertain.
I will try to exemplify this discussion in relation to the
real world:
In February, South African petrochemicals giant, Sasol,
lowered its dividend policy in response to the lowering oil price; however the
day after this news release on February 17th, share prices dropped
5.12% (Figure 1) as this evidently induced shareholder fear. Sasol themselves
stated the reduction in dividend will allow the company to manage cash flexibly
within its balance sheet, ultimately allowing the company to execute its growth
strategy whilst continuing to return value to its shareholders to some extent.
Figure 1: Sasol
Share Price February 1st – February 27th
Source: Google Finance,
2015
Upon seeing this news and the market reaction, other
petroleum companies have more recently either chosen to maximise their dividend
policies (Exxon) or maintain them (BP, Shell, and Chevron). These companies
face the exact same volatile industry as Sasol, but have perhaps gauged the
market reaction towards Sasol’s dividend policy change and opted to signal
greater confidence to its investors. For example, Exxon stated in early April
that the company was increasing its dividend pay-out and Figure 2 provides evidence to suggest the market responded
positively to the news. However, this may not be the best strategic move for
Exxon’s sustainability. The company recently fell behind Shell as top revenue
in the industry and has also invested less capital into its operations over the
past four years. It is debatable to suggest this policy is best for Exxon’s
long-term position and returns, but only time will tell.
Figure 2: Exxon
Share Price March 20th – April 20th
Source: Google Finance,
2015
Here we can see an evident difference between the
shareholder response towards companies utilising a high pay-out dividend policy and a fluctuating dividend policy. This example potentially provides
support for the “bird in the hand” argument (Lintner, 1956), as shareholders respond more
positively towards short-term dividend payments, as opposed to future gains. It
also suggests that even if a company is not fully convinced internally its
future performance will match up to previous standards, playing it cool and
reassuring investors with steady dividend payments is the first step to take to
control any sporadic market fears.
The question posed: is this method suitable for a company to
take if it craves for long-term success?
