Homemade Dividends

Dividends are the distributed part of a company's profit and are one of the major ways (apart from a share repurchase program) in which a company offers cash rewards to its shareholders. The alternative is to retain the earnings in a hope of faster growth or to save for the rainy day. The company can also choose to offer non - cash rewards to the shareholders through stock - dividends or stock - splits.

I am focusing only on cash dividends here and there are a number of school of thoughts that consider the dividend policy of a company as an (un)important factor affecting its value. It should be remembered from the outset that dividends are always important. The debate is about the dividend policy. What is dividend policy?

Dividend policy is the choice between paying the dividends now or later and the literature offers arguments both for the relevance (for example, the signaling theory, the Walter model, the traditional position advocated by Graham and Dodd) as well as irrelevance of dividend policy (for example, clientele effect, Miller and Modigilani argument). Apart from these clear - cut 'yay' and 'nay' positions, we have some arguments which seek a middle ground. For example, Myron Gordon's classification of firms as 'growth' firms, 'normal' firms and 'declining' firms and the (ir)relevance of dividend policy to each one of them. We also have J. F. Muth's Rational expectations hypothesis. It proposes that what is important is not what really happens but what was expected to happen. For instance, if you expected the company to announce a high dividend but it didn't do so, you may revise your assessment of the company downwards and vice - versa.

In this post, we talk about the concept of homemade dividend (Miller and Modigilani), which simply means creating a personal dividend policy and ensuring the desired cash inflow in a given period(s). For example, if your company is paying more dividend than you need (well, you may want a lesser dividend receipt due to tax implications), you can receive the dividend check and reinvest the money back in the company (by buying additional shares through a DRIPS program) or anywhere else (perhaps in a tax saving scheme). And if your company is paying you less dividend than you need, you can make up for the shortfall by selling some shares.

If you can achieve your desired cash flow position on your own, then it does not matter to you what kind of dividend policy the company is following and unless you are affected, you are indifferent between quitting or staying with the firm. So, you might as well stay [If you stay, you don't cause a ripple. If you leave (and like you, others do too), then there is a selling pressure on the company's stock, causing it to turn southward].

Of course, this is an over - simplified way of looking at things because it does not consider factors like transaction costs and differential taxation treatment of dividend and capital gain income. However, it is important in understanding just how much relevance dividend policy has on its own, without the distortions caused by market imperfections and for that purpose (which is quite important), the procedure is helpful. Why I say this is because once you establish the pure relationship between the dividend policy and the value of a firm, you can then begin to factor in the imperfections and see how this relationship changes as each imperfection creates its own effect. It may very well be that it is the imperfect market conditions that cause the dividend policy to be relevant and without them, any policy does not have enough teeth to make an impact.

One can get a little philosophical here and muse: In a perfect world, no policy is needed. Everything takes care of itself on its own. Wow!!!

In the following video, I demonstrate the concept of homemade dividend: