Impact of Dividends on Valuation and Investment decisions

Elementary valuation theories focus on dividends as the base for valuing equity shares. It represents the cash flow to the shareholders which is discounted to arrive at the value of shares. However, not all companies distribute dividends and we us other valuation methods to value shares of companies which do not distribute dividends. However, consider this. Dividend theories suggest that if the company believes that reinvesting dividends would lead to better shareholder wealth maximisation, dividends should not be distributed but should be reinvested instead. Accordingly, generally in emerging economies such as India, dividends have a much lower impact on valuation as companies prefer to reinvest the profits or distribute only a small part of the profits to shareholders. This leads to better capital appreciation for the investors and leads to higher valuation for the companies – particularly when the markets are ‘bullish’.

Dividend Payout Policies are sensitive for the companies as it leads to significant judgement by the investors and analysts alike. Between two identical companies (same industry, good management, regular cash flow, good profitability and rising income), if one company pays dividends while the other does not, the one paying dividend is likely to command higher value over the one that doesn’t. Once a company starts paying dividends, it has to ensure that dividends are consistently rising (or at least stable) over the years. A decrease in dividends from an earlier year implies that the company has not been earning good returns for the shareholders.

Usually, dividends are distributed by companies who are stable in their businesses. Businesses who have significant growth opportunities prefer to retain their profits and thus provide better capital appreciation for investors by earning higher profits. Paying out a higher proportion of profits as dividends may erode shareholder value in the long term due to rationalisation in valuation ratios—PE and PB—which take future growth in earnings and book value into account and also due to tax effects. For example, companies declaring dividends have to pay Dividend Distribution Tax (DDT) which leads to lower cash income at the hands of the shareholders. On the other hand, long term profits earned from traded equity shares are exempt as Long term Capital Gains [As of AY 2014-15 in India, Long Term Capital Gains from traded equity shares is exempt; DDT is charged at an effective rate of 16.995%.]