Question

Why does the value of a share of stock depend on dividends?

A substantial percentage of the companies listed on the NYSE and the NASDAQ don’t pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible with equity risk and liquidity risk?

Referring to the previous questions, under what circumstances might a company choose not to pay dividends?

Answer 1

Solution:-

When an investor invests in shares of a company, he is essentially investing in the business of that company and becomes part owner of that business which entitles him to a proportionate share in the profits of the company. Dividend is that part of company's profits which are distributed out as cash to shareholders. On the contrary, a company may choose to not distribute those profits and rather reinvest them in the business for the purpose of expansion of the existing business or acquisition of new businesses. So, we see that dividend distribution is only of the multiple uses of shareholder profits that can be resorted to by the management and it should not be assumed that more the dividends, better would be the impact on the share value.

Why does the value of a share depends on dividends?

Dividend is one of the most important factors that can significantly impact the value of shares. However, as shared above this doesn't always mean that more dividends is always better and results in increase in the value of shares. Dividend is a crucial factor in the way that they provide a liquid form of income to shareholders and thus is generally considered as a good thing from the perspective of investors. However, it could very well be possible that shareholders may not prefer to always have dividends and rather want management to use the business profits to expand the business and increase market share which increases future earnings. In such a case, if management distributes dividends rather than expansion, it could possibly have a negative impact on value of shares as well.

This is why while the value of a share depends on dividends it comes with the fact that dividends can both increase or decrease the value of shares.

Why do shareholders invest in companies that don't pay dividends?

As described above, the viability of dividend is dependent on case to case basis and is dependent on multiple factors such as:

• Opportunities of organic business growth
• M&A opportunities for the business
• Industry competitive scenario
• Existing levels of debt and access to financing

Thus, it happens very often that the companies that are in growth industries (not mature like e.g. coca-cola) reinvests business profits rather than distributing them as dividends. Investors still choose to invests in such companies because it results in the increase in future earnings of the business due to expansion and growth. So, while they give up the current profits, it is like making further investments in the business which increases the level of future earnings and thus opportunities for increased levels of dividends in the future.

Another reason for shareholders choosing to invest in such companies is that instead of dividend income, they achieve increase in their wealth through capital appreication in the value of their shareholdings in the market. Thus, while liquid income is given up, the overall wealth of shareholders sees bigger gains, more than making up for dividends. This capital appreciation covers the equity risk and liquidity risk for the investors.

Under what circumstances a company may not pay dividends?

• When the management sees ample opportunities for reinvestment in expansion of business and achieving organic growth
• When the management forsees potential targets for mergers and acqusitions
• If the business doesn't have great access to new capital, management will be cautious to distribute dividends, thus ensuring financial stability of company's balance sheet
• If the tax laws related to dividend distribution or receipts are adverse for investors and they would be rather better off to get their returns through capital appreciation