Dividend Irrelevance Theory and the Value of Cash

Greetings all, this is KOPL here with a subject matter that I find rather interesting. As a proponent of dividend investing, I am of the opinion that one should focus on finding good dividend stocks that can supplement their income. Hence, when I came across Dividend Irrelevance Theory, I found myself questioning whether pursuing dividends was even beneficial in the long run. To answer that question, I gathered others' opinions from forums, and my social circles and pondered the theory myself. 

For the uninitiated, Dividend Irrelevance Theory argues that the fact that a company pays dividends does not affect a stock's total return.  To better illustrate this idea to you, I have a theoretical case study we can analyse together as shown below:

In our hypothetical scenario, we have two shareholders - Elgin and Gerald, who each have $1000.

Elgin invests $1000 in Company A to obtain 100 shares. Company A has a good year and earns a good 10% ROE from its business operations, hence, it declares a dividend distribution of $1 per share. Hence, Elgin receives $100 in cash and the share price remains at $10 per share as Net Asset Value (NAV) has remained the same. Elgin's total holdings are now worth $1100. 

Gerald invests $1000 in Company B, a similar company to obtain 100 shares as well. Company B earns a 10% return on its business operations but does not declare a dividend distribution. Since 100 shares of Company B now come along with $100 in cash, the market prices this accordingly, resulting in an increased share price of $11. Gerald's total holdings are now worth $1100 as well.

From the above information, it can be seen that both of their investing performances have no difference.

Now that we have properly presented the case for Dividend Irrelevance Theory, as you can see from this article's title, we have made a bold assumption. How does the market even value companies' excess cash? The market represents the culmination of investors' and financial institutions' valuations of companies. Just because the company has essentially transferred wealth from itself to shareholders, it doesn't mean the share price will rise or drop to exactly reflect that value. 

So, what is the value of cash? Or at least, the perceived value of cash? 

I wish I could say that I had the opportunity to consult numerous financial pundits, investment analysts, and hedge fund managers, but alas, I did not. Instead, I discussed this issue with random people on the internet, alongside close friends. Although like you and me, they most likely wouldn't know how the market behaves, we have managed to come up with a few conclusions. 

It all boils down to the competency of the company management, alongside the state of the economy. 

Cash should be priced at a slight discount when the management has shown no indication of properly utilising it. Imagine a company that is sitting on piles and piles of cash, simply leaving it in the corporate bank to earn that whopping 0.1% or so interest rate. Why should I, as an investor, price such a company's cash at a 1:1 ratio whilst at the same time relinquishing my control over that financial capital? A discount should be applied to reflect the opportunity cost and risk I have incurred. That cash could be used to start a business, invest in high-yielding stocks, and put into fixed deposits, bonds, and bills. All of those possibilities would probably generate a higher interest than just leaving it in the bank. 

Additionally, cash could be valued at a 1:1 ratio when management has shown that their interests are aligned with shareholders' and regularly pay out dividends. With a stable track record of dividends, one can be reassured that their cash will most likely just end back to them in a short period of time. 

The last case proves to be rather interesting to me, which is when do you place a premium on cash? Let's take shares of Berkshire Hathaway for example, with a current Price to Book ratio of 1.49. Understandably, this can be attributed to the nature of the companies that they own which may be asset-light. However, I sure as hell would pay a premium for Warren Buffett, one of the GOATs (Greatest of All Time) in the investing world to manage my money for me. Another possibility as to why cash is possibly priced at a premium is when an economic recession hits. The premium placed on excess cash is to reflect the cost savings from not having to take on debt if earnings are heavily impacted, or the opportunities to acquire distressed companies at attractive valuations which only companies can do (I am assuming you are an average Joe just like me).

Okay, but what exactly does the value of cash have to do with Dividend Irrelevance Theory?

Let's go back to our previous case study of Elgin and Gerald. If both companies were stable companies that are long past their growth phase, there is a high chance that they wouldn't use it for massive acquisitions or research and development (R&D). Hence, the market, according to our findings, would price the excess cash at a discount. By realising the $100 of gains via dividends, Elgin would actually be better off than Gerald since the stock price would presumedly drop less than the cash distributed. 

However, if the company was a growth company, or in an economic recession, then cash would possibly be priced at a premium. Consequently, the opposite will be true, where Gerald will be better off than Elgin. 

If you ask me, I find highly competent management teams to be rarer than adequate ones. Hence, my positions on dividends being beneficial to one's portfolio is yet to be changed. 

Parting Thoughts

I must admit that this article has not considered many other factors, such as the argument that dividends essentially force you to realise share gains, which removes the psychological aspect of selling which may be beneficial, or the fact that dividend investing allows one to reinvest the dividends and compound their stake in the company. 

However, I hope that by reading this blog article, you have considered some new perspectives when it comes to the Dividend Irrelevance Theory, as well as be able to consider the various nuances when it comes to such discussions. 

Think this article is something you'd want more of? Subscribe here using your email to get notified about my latest blog articles, I'd truly be grateful!

Disclaimer: Please take everything published within this blog with a pinch of salt. Nothing I say here should be misconstrued as any form of financial advice whatsoever. In fact, I am probably the absolute last person you should approach for any sort of advice.

Thank you for reading my blog, and I hope you have learnt something, no matter how seemingly minuscule. I would greatly appreciate it if you subscribe as such posts take a decent chunk of time to dish out, ciao!