Dividend Policy and Share Value
Introduction
The dividend policy of a company determines what proportion
of earnings is distributed to the shareholders by way of dividends,
and what proportion is ploughed back for reinvestment purposes.
Since the main objective of financial management is to maximise
the market value of equity shares, one key area of study is
the relationship between the dividend policy and market price
of equity shares.
There are four models available to show the above relationship,
these are briefly described as follows:
Traditional model: according to this model founded
by Graham and Dodd, the market price of the shares will increase
when a company declares a dividend rather than when it does
not. Quantitatively P=m (D+E/3)
Where:
P is the market price per share
M is a multiplier
D is the dividend per share
E is the earning per share
Walter model: according to this model founded by James
Walter, the dividend policy of a company has an impact on
the share valuation.
Quantitatively P=(D+(ED) r/k)/k
Where:
P, D, E have the same connotations as above and r is the
internal rate of return on the investments and k is the cost
of capital.
The impact of dividend payment on the share price is studied
by comparing the rate of return with the cost of capital.

When r>k, the price per share increases
as the payout ratio decreases (optimal payout ratio is
nil)

When r=k, the price per share does not
vary with the changes in the payout ratio (optimal payout
ratio does not exist)

When r<k, the price per share increases
as the payout ratio increases (optimal payout ratio is
100%)
Gordon model: according to this model founded by Myron
Gordon, the dividend policy of the company has an impact on
share valuation.
Quantitatively P= Y (1b)/(kbr)
Where P is the price per share
Y is the earnings per share
b is the retention ratio
1b is the payout ratio
br is the growth rate
r is the return on investment
k is the rate of return required by shareholders
On comparing r and k, the relationship between market price
and the payout ratio is exactly the same as compared to the
Walter model.
MM model: according to this model, as founded by Miller
and Modiliani, the market price of the share does not depend
on the dividend payout, i.e. the dividend policy is irrelevant.
This model explains the irrelevance of the dividend policy
in the following manner:
When profits are used to declare dividends, the market price
increases. But at the same time there is a fall in the reserves
for reinvestment. Hence for expansion, the company raises
additional capital by issuing new shares. Increase in the
overall number of shares, will lead to a fall in the market
price per share. Hence the shareholders would be indifferent
towards the dividend policy.
