Question

By paying out a dividend, a company has that much less to continue its growth. From the investors standpoint, it can depend on individual preference on which is better: getting a dividend distribution that gives profit, or having the company reinvest all profits for future growth (even if that growth is currently slow) in the effort to continue to raise the stock price. Can the decision to apply the profit for future growth impact the stock price?​

Answer 1

1) According to financial theory on dividend policy, the dividend decisions does not matter. This is based on the assumption of a perfect capital market where assets are valued to their true intrinsic value and where there is no possibility of making excess returns. Mathematically, this means for every company the return on assets should be equal to its cost of capital. In a perfect market, if a company makes a return greater than its cost of capital, more companies will enter into that business in order to share the excess profits available. This will reduce the attractiveness and availability of high NPV projects. At the same time, this will also raise the cost of capital as the demand for capital will exceed supply. Over a period of time, the high ROA will come down while cost of capital will increase so that no firm will be able to make any return greater than its cost of capital (which will be in tune with its business risk).

In such a perfect market, the company and investors earn the same return - companies earn RoA while investors earn Required rate of return which is same as cost of capital. This means if the company distributes dividends, the investors will be able to invest in some other avenue at the cost of capital. So, it does not matter whether the free cash flow is retained for further growth giving return of required rate of return implied in cost of capital or distributed to investors.

So, in such perfect markets where there is equibrium between required rate of return and return on assets, the stock price will not be impacted by whether dividend is distributed or retained for further growth.

2) In real world, due to inefficiencies in asset markets, the return on assets could be greater than cost of capital. In that case, if the company retains free cash flow for further growth, it will earn this higher RoA which leads to appreciation in stock price over a period of time giving capital gains to investors. But if the company distributes this free cash flow to investors even when its RoA is greater, the investors will loose as they will be able to invest only at the required rate of return equal to cost of capital. Hence, as long as RoA > WACC, the company should retain profits for further growth.

In this case, increasing the retention ratio will allow the company to grow its value and hence the stock price will appreciate and provide greater return through capital gains than dividend yield if distributed. This is what most companies do as there are always opportunities for high NPV projects which are not available for investment by investors.

3) It is also possible for companies to issue dividends in order to maintain its historical dividend record even when it has high growth expansion projects. In that case, the company will raise fresh finance in terms of equity or debt depending on its optimal capital structure.

This practice of issuing dividends while raising finance at the same time will not change the stock price which will continue to reflect the same growth implied in the stock price when it decides not to issue dividends and retain the profits for future growth.

So, as long as company has potential for higher growth through achievement of excess returns through high NPV projects which is greater than returns available to the investor in the market, retaining profits will increase the share price reflecting future growth in value of the firm