Question

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First you should explain the relationship between dividends and stock prices with reference to the dividend discount model. As dividends are of two types i.e. cash dividends and stock dividends, what are the reasons for giving either type of dividends and does giving of such dividends affect the stock price? In your answer also bring in the discussion about dividend yield and dividend payout ratio. Link in your answer a discussion of profits and retained earnings with dividends. Should you buy shares of firms that pay dividends or should you buy growth stocks; are firms that pay high dividends good or those that pay low dividends – why?

Answer 1

As per the dividend discount model, the value of a stock is equal to the present value of all future dividends discounted at the required rate of return. Hence, the DDM uses dividends to value share price of a Company.

A Company pays dividends as a reward to its shareholders, and out of the profits remaining after meeting all operational and financial obligations. It can be paid in the form of cash when a Company has excess/surplus cash or in the form of shares via which a shareholder receives some new shares for every share unit he holds. Stocks that pay consistent dividends are quite popular among the shareholders as it gives an impression that the Company is making enough profits to sustain itself as well as reward the owners.Such companies are perceived to be financially stable companies.

Dividend yield refers to dividend expressed as a percentage of market price of share. (DPS/MPS)

Dividend payout is the ratio of dividend declared to shareholders to the net income of the Company. (DPS/EPS)

Since I am an investor who values financial stability more than growth, I would prefer a dividend paying stock over a stock opting for growth opportunities by not declaring dividend.

The declaration of a dividend naturally encourages investors to purchase stock. When companies display consistent dividend histories, they become more attractive to investors. As more investors buy in to take advantage of this benefit of stock ownership, the stock price naturally increases, thereby reinforcing the belief that the stock is strong. If a company announces a higher-than-normal dividend, public sentiment tends to soar.