What does the dividend level say about the company giving out the dividend? And should companies set their dividend levels to try to please their shareholders? In this lesson, we'll explore two theories about dividends: the information content theory and clientele effect.
What Are Dividends?
Sarah is the CEO of a publicly owned company. That is, her company is for sale on the stock market, and anyone can buy shares. One goal of Sarah's company, like all publicly owned companies, is to attract more investors to buy shares of the company. Sarah wonders how she can do this. One way to entice people to buy shares of a company is to offer dividends, or payments to stockholders, from the company's income. Dividends could be paid in cash, more stock, or a number of other ways. The most common type of dividend is a cash dividend.
Sarah thinks that her company should pay out a dividend to their shareholders to help entice people to invest. But she's not sure about whether it's better to pay a low or high dividend. Does it matter how much of a dividend she offers? To answer that question, let's take a look at the information content of dividends and the clientele effect and what they say about how to set the price of dividends.
Information Content Theory
As we've seen, Sarah wants to know whether her company should distribute a high dividend or a low dividend to their stockholders. The information content of dividends theory says that a high dividend indicates that the company is strong and a good investment. The idea is that if a company pays out a high dividend, it is because it is financially sound and will earn a lot in the future. Intuitively, Sarah can see where the information content of dividends theory comes from. After all, if her company makes $1 million, their dividends are likely to be lower than if the company makes $100 million.
But there's a problem with this theory. Namely, companies know that many people see dividend levels as indicative of future earnings and that high dividends can attract more investors, thus driving up the stock price and bringing in more money. Because of that, some companies can set a higher dividend level just to try to make people believe that the company is doing well and entice investors to buy. Whether the information content of a dividend payout is an accurate reflection of how a company is doing and how it will do in the future or not, though, the market usually responds to dividend levels as though they provide valuable information.
The Clientele Effect
Based on how people are more likely to buy a company's stock if their dividend is high, Sarah thinks that her company should provide a high dividend to the stockholders. But is it always best to provide high cash dividends? Some companies choose to provide lower cash dividends in order to attract a specific type of investor. Because investors differ in their needs and in their tax brackets, some prefer high cash dividends, and others actually prefer low cash dividends.
To understand why, let's look at Sarah and her mother, Margaret. Sarah and Margaret are very different. Sarah is young and earning a lot of money. She's in a very high tax bracket. Margaret, on the other hand, is older and retired. She's in a very low tax bracket. Now, if Sarah receives a high cash dividend, it will be taxed at a very high rate. For her, it's better for the company to give out a low cash dividend and invest the rest of the company's profits back in the company. But Margaret is on a fixed income and could really use the cash from the dividend to help pay her bills. If she gets a high cash dividend, it will be taxed at a very low rate, so that's the better option for her.
In general, investors in high tax brackets, like young, high-earning individuals, prefer low cash dividends. In contrast, investors in low tax brackets, like retired individuals and non-profit companies, prefer high cash dividends.
So, how can Sarah's company set the dividend amount? It seems like either way, they'll be disappointing some of their investors. The clientele effect says that investors who want a high dividend will invest in companies that pay a high dividend, and those who want a low dividend will invest in companies that pay a low dividend. In other words, it doesn't really matter what the company does as long as they stay consistent. In other words, if Sarah's company regularly provides relatively small cash dividends, they will attract investors who are in high tax brackets and should continue to provide small cash dividends. But there's no real reason to change what they're doing just because Margaret says that she'd prefer a larger cash dividend; if that's the case, she can invest elsewhere.
Dividends are payments to stockholders from the company's income. Dividends could be paid in cash, more stock, or a number of other ways. The most common type of dividend is a cash dividend. The information content of dividends theory says that a high dividend indicates that the company is strong and a good investment. As a result, a high dividend is likely to drive up the price of a company's shares.
In general, investors in high tax brackets, like young, high-earning individuals, prefer low cash dividends. In contrast, investors in low tax brackets, like retired individuals and non-profit companies, prefer high cash dividends. The clientele effect says that investors who want a high dividend will invest in companies that pay a high dividend, and those who want a low dividend will invest in companies that pay a low dividend.