Value of eliminated dividends is offset by growth-created value in the future
The increased return on the retained earnings offsets the reduction or elimination of dividends
Thus, the current stock price is independent of changes in early dividends
Investors can tailor their income stream by selling shares of a growing stock that doesn’t pay dividends or by buying shares of stock of a company that pays more dividends than an investor needs
The Dividend Controversy—Irrelevance—Example Example Q: The Winters are retirees with most of their savings invested in 10,000 shares of Ajax Corporation (AJAX). AJAX sells for $10 per share and pays an annual dividend of $0.50 per share. This year AJAX eliminated the dividend but began to grow at 5% a year due to the reinvested earnings. How can the Winters maintain their income and their position in AJAX? A: Their original value of AJAX shares was $10 per share 10,000 shares, or $100,000, which they wish to maintain. But, they were generating an annual dividend of 10,000 shares $0.50 or $5,000 before AJAX eliminated the dividend. After one year of 5% growth, AJAX’s shares should be selling for $10.50. Thus, by selling 476 shares ($5,000 $10.50) they can generate $5,000 in cash. Their remaining 9,524 shares would be worth $10.50 each for a total of $100,002.
Current stockholder is issued new shares proportionate to his current holdings
No change in ownership control occurs
Same as a stock split but called a stock dividend if the number of shares is less than or equal to 20% of original shares outstanding
Stock Splits and Dividends A firm with 100,000 shares outstanding executes a 2-for-1 split. Each stockholder will now have twice as many shares as they had before. The firm will now have 200,000 shares outstanding. Each share is worth half as much as before the split. Example
Johnson Company currently has 2,500,000 outstanding shares of common stock and Net Income of $5 million. The firm’s P/E ratio is 10. Thus, Johnson’s EPS is $5,000,000 2,500,000 or $2.00 per share; and the firm’s market price is $2.00 x 10 or $20. Johnson has $1 million in cash available for distribution to stockholders.
If the firm distributes it as a dividend, the firm will pay a dividend of $0.40 per share, or $1,000,000 2,500,000 shares.
If the firm instead buys back its own shares, it will be able to retire 50,000 shares, or $1,000,000 $20. There would then be 2,450,000 shares outstanding and EPS would be $5,000,000 2,450,000 or $2.04 per share. If the firm’s P/E ratio remains unchanged, the firm’s stock price should rise to $20.40, or $2.04 x 10.