Do Dividends Matter? (Part I) What Modigliani And Miller Really Say

Includes: DIA, MSFT, QQQ, SPY, T
by: James A. Kostohryz
A fierce debate is raging regarding the fundamental basis for dividend investing. Some analysts believe that dividend investing constitutes a fundamentally sound technique that may be recommendable to many investors. Other analysts take the view that dividend investing is fundamentally “dumb.”
I want to state from the outset what my own position is.
First, understanding why dividends might or might not matter is not a simple matter. Highly distinguished economists, including Nobel Prize winners, have differed over this issue. For example, Nobel Laureate Franco Modigliani was of the view that dividend policy was essentially immaterial. By contrast, Nobel Laureate Paul Krugman recently weighed in on the debate, essentially stating that dividends are the only thing that matter. The very fact that individuals that are obviously very intelligent differ on this issue is a clear sign that people should approach this subject with humility. Even if one believes that one is correct, one should allow for the fact that this is a difficult subject that other intelligent people can easily get confused about.
Second, it is my position that dividends do matter. I believe that I have a relatively unique point of view to offer on this subject and I will develop it over a series of articles. I beg reader’s patience because the subject is not an easy one.
In the first article in this series I propose to examine what Modigliani and Miller had to say on the subject and derive some conclusions from this.
Did Modigliani And Miller Really Say That Dividends Do Not Matter?
By far, the most influential piece of scholarship that has ever been written on the subject of dividends was put forth by two Nobel winning economists: Franco Modigliani and Merton Miller (M&M). In their seminal paper, “Dividend Policy, Growth, and the Valuation of Shares,” M&M proposed an analytical framework which subsequently became widely known as the “dividend irrelevance theorem.”
Indeed, arguments against dividend investing gain immediate credibility and prestige because they are associated with the M&M theorem.
However, critics overplay their hand when they invoke M&M in support of the blanket proposition that dividends are irrelevant. It is time to deflate that bubble and set the record straight: Modigliani and Miller did not say that dividends were irrelevant.
What M&M said was something that was much more qualified than that. Clearly comprehending exactly what they said and did not say can serve as an important first step in understanding whether dividends matter.
What Did Modigliani And Miller Really Say About Dividends
In order to answer the question regarding exactly what M&M really said about dividends in their seminal paper, I will quote Merton Miller himself:

We argued in our paper that if you hold constant the use represented by the firm’s capital budget, that is, its investment spending, then paying out more dividends just means you will have to raise more funds from bank loans or outside flotations of bonds or stocks. A firm’s choice of dividend policy, given its investment policy, is thus really a choice of financing strategy. Does the firm choose to finance its growth by relying more heavily on external sources of funds (and paying back some of those funds in higher dividends) or by cutting its dividends and relying more heavily on internal funds?

Put this way, it is by no means obvious that the generous dividend/heavy outside financing strategy is always the best one, or vice versa. In fact, when we academics say that dividend policy doesn’t matter much, we are really saying only that, given the firm’s investment policy (which is what really drives its engine), the choice of dividend/financing policy will have little or no effect on its value. Any value that the stockholders derive from the higher dividends is more or less offset, because they must give outsiders a bigger share of the pie.

On many occasions and in various forums, Merton Miller was very careful to qualify the claim that “dividend policy doesn’t matter much.” The key qualification is that dividends are irrelevant to the extent that the cash used to pay dividends would increase the amount of debt or equity capital that the firm would have to raise in order to implement its investment program.

Under these clearly specified circumstances, M&M essentially argued that by paying out dividends, corporations take from shareholders with one hand what they give out to shareholders with another. Thus, under these conditions, the appearance of benefiting shareholders via dividend payments is a mere illusion since the benefit from receiving dividend distributions would be offset by the dilution of ownership caused by issuance of new debt and/or equity.
But what about companies such as Microsoft (NASDAQ:MSFT), AT&T (NYSE:T), Verizon (NYSE:VZ) or Intel (NASDAQ:INTC) that generate excess cash? In other words, what happens when a company generates so much cash that it is not able to find appropriate uses of this cash that would exceed the firm’s cost of capital?
In such a circumstance, M&M’s theorem clearly posits that dividend policy is not irrelevant. Capital is best placed where it is valued most. Thus, in cases in which excess cash is generated by the firm, payment of dividends adds to shareholder value since the return on equity capital demanded by investors is greater than the return that the firm is able to obtain on its cash hoard. In this case, capital finds its most valued use in the hands of shareholders.
The possibility of an investor creating “home-made dividends” by selling shares does not alter this conclusion. A firm is destroying capital when its investments yield less than the cost of capital. The fact that an investor can sell shares in the secondary market to raise liquidity does not in any way halt the destruction of value that occurs when a firm invests funds in projects that do not yield the cost of capital.
As we shall see as we progress through the series, this clear distinction laid out by Merton Miller will prove to be critically important in resolving the controversy about dividend investing. For now, we may briefly derive four very straightforward conclusions that necessarily follow from M&M’s theorem:
  • Dividends are relevant because they can add value to shareholders. As a general matter, dividends are not irrelevant; they constitute a highly relevant instrument of value creation. When investors’ need for cash (quantified by the investors’ cost of obtaining capital or their opportunity cost of not possessing capital) is greater than the rate of return that companies can generate with that cash, companies create value for shareholders by paying out this excess cash to shareholders in the form of dividends. Again, the possibility of a shareholder creating “home-made dividends” does not alter the conclusion since what is at issue here is allocative efficiency - the use of capital with the highest rate of return. Homemade dividends can help an investor raise liquidity; it does not alleviate the loss of allocative inefficiency caused by firms applying capital towards sub-optimal uses.
  • Dividends are relevant because they constitute an integral part of efficient capital management. As a corollary to the above, firms add value to shareholders through the careful rationing and use of capital such that they refrain from expenditures that do not generate a rate of return that exceeds the value which shareholders place on capital, and pay out to shareholders all excess cash in the form of dividends. In this sense, dividend payments constitute an integral aspect of a firm’s achievement of capital efficiency. Dividends form the second half of a unity expressed in a double entry: Credit from capital rationing; debit from payment of dividend.
  • Dividends are relevant because they are a net good. According to the M&M theorem, at worse, payment of dividends can (in some circumstances) be irrelevant to the value of the firm to shareholders. When the firm needs cash to complete an investment program it can raise the cash spent on dividend payments by borrowing or issuing equity – it’s a wash. However, in many cases, payment of dividends is a positive good that adds value to shareholders. Far from claiming that dividends are bad, M&M’s theorem actually posits that dividends can help but never hurt shareholder value. The fact that dividends can only help shareholders and never hurt them make them a “net good” and establishes a logical basis for a strong presumption in favor of dividend payments as the general rule. In other words, since dividends can only help and never hurt, company management should be required to demonstrate compelling reasons to not pay dividends out of the cash flow generated by the firm.
  • Dividends are relevant because they promote overall social welfare. Capital is scarce. Thus, the use of capital must be directed toward its most valuable uses. If firms never paid dividends, the societal use of capital would be inefficient. For example, there would be an imbalance between investment and consumption. Furthermore, capital for investment would not be allocated towards higher value-added uses in public investment markets (^SPX, ^DJIA, ^IXIC, ^NDX, SPY, DIA, QQQ). Thus, dividend payments set into motion market dynamics that tend to create an optimal balance between consumption and various investments uses of capital. Shareholders, guided by the price mechanism, choose what the best use of capital is: reinvestment in the company, consumption or direct or intermediated investment in some other value-creating enterprise. The possibility of “home-made dividends” does not address this issue since the sale of shares from one person to another does not alter the fact that non-payment of dividends impedes the mobility of capital and prevents capital from being directed towards its most valued use.
Might dividends add value even if they are paid out in circumstances in which the firm’s investment program requires cash and the firm must raise proportionately higher quantities of cash through debt and/or equity issuances? Modigliani and Miller’s theorem clearly posits that dividend payments neither raise nor add value in this circumstance. However, in a future article I will demonstrate that this postulate is not necessarily correct. There are various circumstances under which dividends can on aggregate add value to shareholders even in this circumstance.
For now I will simply conclude by saying that Modigliani and Miller’s capital structure framework does not provide an adequate basis for a general critique of dividend payments, much less dividend investing. M&M offer a theorem that call into question the value added of dividends in the specific circumstance when a firm requires capital to meet its investment program. In that sense, M&M’s theorem is misnamed. It should not be called the “dividend irrelevance theorem.” It should be called the “dividend relevance qualification.”
And as we shall see in future installments, even this qualification of the relevance of dividends must be qualified further.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.