Do cash dividends increase the value of stocks?
In early 1960s, an American economist by the name of Myron Gordon suggested in his research that when a company pays dividends, it also tends to increase its market value in the long run.
Gordon argued that because future capital gains were uncertain, investors would rather be paid in dividends now than wait for their stocks to appreciate later.
By receiving “bird in the hand” cash dividends rather than the “two in the bush” capital gains, investors are also able to reduce their uncertainties about a company’s earnings in the future.
When uncertainties are less, investment risks are lower too, which help increase share price valuation.
But, in practice, we know that the riskiness of a company is not affected by the way it distributes its cash dividends, but rather by its ability to generate earnings.
When the market has a good reason to expect a company to generate strong returns from its investments, the lower perceived risks can translate into higher share price in the long term, because higher earnings will mean higher dividends, too.
In the same way, when a company faces increasing uncertainties about sustaining growth in the future, rising risk of lower earnings, which may also affect its capacity to pay dividends, can cause share price to fall.
In other words, a company can influence the value of its stock, not by paying dividends, but by investing its capital to generate growth for the future.
One way a company can do this is by reinvesting its earnings. The more earnings a company reinvests, meaning the less dividends it pays out, the higher the sustainable growth rate (SGR) it can achieve.
We can see this in the growth of Ayala Land over the years. In 2014, when the company’s dividend payout was 41 percent, it slowly reinvested its earnings, by cutting down its dividends, as its ROE rose from 13.8 percent in 2014 to 15.7 percent in 2019.
The increase in Ayala’s reinvestment rate from 66 percent in 2015 to 77 percent in 2019 consistently raised its growth potential with rise of its SGR from 8.17 percent in 2014 to 12.1 percent in 2019.
The increase in SGR, which we computed by multiplying the stock’s ROE against its retention rate, resulted to 113 percent rise in share price, which increased from P25.25 in 2014 to as high as P53.80 in 2019.
But in 2020, a massive contraction in earnings from the pandemic lockdown brought down Ayala’s SGR to only 5.6 percent, which caused its share price to lose by 23 percent from its high by year-end.
Historically, the average SGR of the market is directly associated with the changes in the Philippine Stock Exchange index (PSEi) at 21-percent correlation.
The average market SGR has been slowly going up since 2016 from 8.28 percent to 8.51 in 2019, which also saw the rise in the index by 11.6 percent during the period.
The increase in average SGR was influenced by the increased reinvestment activities of PSEi companies, who paid out fewer dividends that pulled down average dividend payout ratios from 35.3 percent in 2016 to 31.6 percent in 2019.
Interestingly, during those years, the expansion efforts of companies belonging from the PSEi yielded lower returns, as average ROE fell from 12.8 percent in 2016 to 12.4 percent in 2019.
The diminishing returns on equity with the contraction in the economy, the trailing average ROE in the market fell sharply to its lowest in years at 7.15 percent.
But, despite the slowdown in earnings growth, most companies paid more cash out of their earnings by an average dividend payout ratio of 50.5 percent, resulting to SGR of 3.5 percent.
The high dividend payout, which means low reinvestment rate, could be an indication of lower growth ahead as companies see fewer good projects to invest in.
Cash dividends are good indicator of a strength of a company because it signals higher earnings in the future, but in a slow growth environment, it also signals lack of value adding investment opportunities. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 88th batch of RFP Program this March 2021.
To register, e-mail [email protected] or text at 09176248110
