Paper Review: Dividend Policy and Common Stock Prices

Author: James E. Walter (1956)

Source: Journal of Finance
Summary
The paper Dividend Policy and Common Stock Prices is an attempt to
fabricate a theoretical model to establish a relationship between dividend
policies and common stock prices. In this paper Walter has restricted his
observation only to common stocks of large public corporations as securities
of small firms have close identification with their principal shareholders
leading to imperfect market. Formulation of the model rest on the
fundamental premise is that, over longer periods, stock prices reflect the
present values of expected dividends.
Methodology
In analyzing the present worth of future dividends, the concept of
capitalization rate has been used. Market capitalization rate for a firm is
defined as the reciprocal of the market multiplier if dividend payout ratio
were 100 per cent. The assumption made for the model is that, the earning
retention is the sole source of additional funds, rates of return on added
investments and the market capitalization rate are constant and all the
increments to earning are immediately distributed to shareholders.
All the common stocks have been grouped into for, namely, growth stock
(low dividend payout ratio), intermediate (medium to high dividend payout
ratio), creditor stock (fixed dividend rates) and declining stock. Diversity of
dividend policy is used to differentiate these groups.
For growth stocks, Stock price is expected to vary inversely with dividend
payout ratio if Ra exceeds Rc.
D+
V c=

Ra
( ED )
R c+ p
Rc

Where,
Vc = Present value of common stock
D = Cash Dividend
E = Earning
Ra = Rate of return on additional investment
Rc = Market capitalization rate
P = Diversification premium

Paper also suggests relation between retained earnings and dividends if

there is preferential tax treatment of capital gain versus that of dividend
income.
t
R a= R c
s
Where,
t = 1 - marginal tax rate on personal income
s = 1 tax rate on capital gain
Because of preferred tax treatment of capital gains, common stocks may
assume the characteristics of growth stocks despite the fact that rates of
return on added investment are less than market capitalization rates.
For Intermediate and creditor stocks stock prices are directly related to
dividend payout ratio.
Conclusion
In case of growth stocks, low dividend payout ratios is expected to enhance
stock values. Whenever rates on return on additional investment exceed
market capitalization rates, the common stock in question belongs to the
growth stock category.
For larger firms, rate of returns on additional investment are less than the
market capitalization rate leading to direct relationship between stock prices
than dividend payout ratio.