Question

Discuss the 3 different views on how dividend policy affects stock prices.

Answer 1

A public or private corporation's dividend policy results from decisions by management and the board of directors over how much cash flow should be used to return to stockholders. Dividends typically take the form of quarterly checks, but can also be distributed in additional company stock. They are a key barometer of a company's health, and how investors perceive them directly affects the stock price. The following are some of the main factors which affect the stock price by dividend policy.

• Use of Cash Flow:- The high-growth companies may choose to invest all of its free cash flow into the business rather than return money to shareholders. Seeking to take advantage of bright prospects and gain an edge on the competition, a corporation will deploy all available resources to growth. Investors recognize this reality and often reward such companies with a high stock price despite the lack of dividends.

• Cause and Effect:- A company typically announces a dividend increase in the same press release as a positive quarterly earnings report. The combination of both favorable events often leads to an immediate increase in the share price, even on days when the overall market may be down. The announcement of a dividend cut may lead to the expected stock price decline, but it could also signal that a company is taking the necessary steps to reduce debt and put its financial house in order.

• Management Discretion:- Over time, investors learn to trust this discretion in light of a strong track record. Managers, however, may focus on risky projects or acquisitions that require large cash allocations at the expense of higher dividends. While the free-market system is inherently risky, a company's cash belongs to its stockholders.

• Taxation Of Dividends:- Although most corporate dividends are "qualified" and taxed at a special rate, you have to hold a stock for 61 days or more to earn that status. This means your first couple of dividends will be taxed at your ordinary-income tax rate. If you intend to buy and sell stocks immediately before and after their ex-dividend dates simply to capture the dividends, you may face a large tax bill. You'll also have to factor in the commission you may have to pay every time your buy or sell a stock.