# Dividend Policy, Growth, and the Valuation of Shares

TL;DR: In this paper, the effect of differences in dividend policy on the current price of shares in an ideal economy characterized by perfect capital markets, rational behavior, and perfect certainty is examined.

Abstract: In the hope that it may help to overcome these obstacles to effective empirical testing, this paper will attempt to fill the existing gap in the theoretical literature on valuation. We shall begin, in Section I , by examining the effects the effects of differences in dividend policy on the current price of shares in an ideal economy characterized by perfect capital markets, rational behavior, and perfect certainty. Still within this convenient analytical framework we shall go on in Section II and III to consider certain closely related issues that appear to have been responsible for considerable misunderstanding of the role of dividend policy. In particular, Section II will focus on the longstanding debate about what investors "really" capitalize when they buy shares; and Section III on the much mooted relations between price, the rate of growth of profits, and the rate of dividends per share. Once these fundamentals have been established, we shall proceed in Section IV to drop the assumption of certainty and to see the extent to which the earlier conclusions about dividend policy must be modified. Finally, in Section V , we shall briefly examine the implications for the dividend policy problem of certain kinds of market imperfections.

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TL;DR: In this paper, a theoretical valuation formula for options is derived, based on the assumption that options are correctly priced in the market and it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks.

Abstract: If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.

28,434 citations

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TL;DR: In this article, the authors predict that corporate borrowing is inversely related to the proportion of market value accounted for by real options and rationalize other aspects of corporate borrowing behavior, such as the practice of matching maturities of assets and debt liabilities.

12,521 citations

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TL;DR: In this article, the problem of selecting optimal security portfolios by risk-averse investors who have the alternative of investing in risk-free securities with a positive return or borrowing at the same rate of interest and who can sell short if they wish is discussed.

Abstract: Publisher Summary This chapter discusses the problem of selecting optimal security portfolios by risk-averse investors who have the alternative of investing in risk-free securities with a positive return or borrowing at the same rate of interest and who can sell short if they wish. It presents alternative and more transparent proofs under these more general market conditions for Tobin's important separation theorem that “ … the proportionate composition of the non-cash assets is independent of their aggregate share of the investment balance … and for risk avertere in purely competitive markets when utility functions are quadratic or rates of return are multivariate normal. The chapter focuses on the set of risk assets held in risk averters' portfolios. It discusses various significant equilibrium properties within the risk asset portfolio. The chapter considers a few implications of the results for the normative aspects of the capital budgeting decisions of a company whose stock is traded in the market. It explores the complications introduced by institutional limits on amounts that either individuals or corporations may borrow at given rates, by rising costs of borrowed funds, and certain other real world complications.

9,970 citations

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12 Sep 2011TL;DR: In this paper, the authors deduced a set of restrictions on option pricing formulas from the assumption that investors prefer more to less, which are necessary conditions for a formula to be consistent with a rational pricing theory.

Abstract: The long history of the theory of option pricing began in 1900 when the French mathematician Louis Bachelier deduced an option pricing formula based on the assumption that stock prices follow a Brownian motion with zero drift. Since that time, numerous researchers have contributed to the theory. The present paper begins by deducing a set of restrictions on option pricing formulas from the assumption that investors prefer more to less. These restrictions are necessary conditions for a formula to be consistent with a rational pricing theory. Attention is given to the problems created when dividends are paid on the underlying common stock and when the terms of the option contract can be changed explicitly by a change in exercise price or implicitly by a shift in the investment or capital structure policy of the firm. Since the deduced restrictions are not sufficient to uniquely determine an option pricing formula, additional assumptions are introduced to examine and extend the seminal Black-Scholes theory of option pricing. Explicit formulas for pricing both call and put options as well as for warrants and the new "down-and-out" option are derived. The effects of dividends and call provisions on the warrant price are examined. The possibilities for further extension of the theory to the pricing of corporate liabilities are discussed.

9,635 citations

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8,252 citations

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TL;DR: In this article, the effect of financial structure on market valuations has been investigated and a theory of investment of the firm under conditions of uncertainty has been developed for the cost-of-capital problem.

Abstract: The potential advantages of the market-value approach have long been appreciated; yet analytical results have been meager. What appears to be keeping this line of development from achieving its promise is largely the lack of an adequate theory of the effect of financial structure on market valuations, and of how these effects can be inferred from objective market data. It is with the development of such a theory and of its implications for the cost-of-capital problem that we shall be concerned in this paper. Our procedure will be to develop in Section I the basic theory itself and to give some brief account of its empirical relevance. In Section II we show how the theory can be used to answer the cost-of-capital questions and how it permits us to develop a theory of investment of the firm under conditions of uncertainty. Throughout these sections the approach is essentially a partial-equilibrium one focusing on the firm and "industry". Accordingly, the "prices" of certain income streams will be treated as constant and given from outside the model, just as in the standard Marshallian analysis of the firm and industry the prices of all inputs and of all other products are taken as given. We have chosen to focus at this level rather than on the economy as a whole because it is at firm and the industry that the interests of the various specialists concerned with the cost-of-capital problem come most closely together. Although the emphasis has thus been placed on partial-equilibrium analysis, the results obtained also provide the essential building block for a general equilibrium model which shows how those prices which are here taken as given, are themselves determined. For reasons of space, however, and because the material is of interest in its own right, the presentation of the general equilibrium model which rounds out the analysis must be deferred to a subsequent paper.

15,342 citations

### "Dividend Policy, Growth, and the Va..." refers background in this paper

...1 Apart from the references to it in our earlier papers, especially [16], the closest approximation seems to be that in Bodenborn [1, p....

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...The equivalence of the dividend approach to many of the other standard approaches is noted to our knowledge only in our [16] and, by implication, in Bodenhorn [1]....

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TL;DR: In this article, the Stockholm School hypothesis is used to explain how expectations are formed in the context of an isolated market with a fixed production lag, and commodity speculation is introduced into the system.

Abstract: In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory. In particular, the hypothesis asserts that the economy generally does not waste information, and that expectations depend specifically on the structure of the entire system. Methods of analysis, which are appropriate under special conditions, are described in the context of an isolated market with a fixed production lag. The interpretative value of the hypothesis is illustrated by introducing commodity speculation into the system. 1. INTRODUCTION THAT EXPECTATIONS of economic variables may be subject to error has, for some time, been recognized as an important part of most explanations of changes in the level of business activity. The "ex ante" analysis of the Stockholm School-although it has created its fair share of confusion-is a highly suggestive approach to short-run problems. It has undoubtedly been a

4,984 citations

01 Jan 1956

TL;DR: Lintner as discussed by the authors discusses the distribution of income of corporations among dividends, retained earnings, and taxes in the context of the Sixtyeighth Annual Meeting of the American Economic Association.

Abstract: Distribution of Incomes of Corporations Among Dividens, Retained Earnings, and Taxes Author(s): John Lintner Source: The American Economic Review, Vol. 46, No. 2, Papers and Proceedings of the Sixtyeighth Annual Meeting of the American Economic Association, (May, 1956), pp. 97-113 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1910664 Accessed: 26/06/2008 14:06

3,524 citations

### Additional excerpts

...stabilization and target ratios see Lintner [15]....

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...29 For evidence on the prevalence of dividend stabilization and target ratios see Lintner [15]....

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TL;DR: In this paper, three possible hypotheses with respect to what an investor pays for when he acquires a share of common stock are evaluated by deriving the relation among the variables that follows from each hypothesis and then testing the theories with cross-section sample data.

Abstract: T HE three possible hypotheses with respect to what an investor pays for when he acquires a share of common stock are that he is buying (i) both the dividends and the earnings, (2) the dividends, and (3) the earnings. It may be argued that most commonly he is buying the price at some future date, but if the future price will be related to the expected dividends and/or earnings on that date, we need not go beyond the three hypotheses stated. This paper will critically evaluate the hypotheses by deriving the relation among the variables that follows from each hypothesis and then testing the theories with cross-section sample data. That is, price, dividend, and earnings data for a sample of corporations as of a point in time will be used to test the relation among the variables predicted by each hypothesis. The variation in price among common stocks is of considerable interest for the discovery of profitable investment opportunities, for the guidance of corporate financial policy, and for the understanding of the psychology of investment behavior.' Although one would expect that this interest would find expression in cross-section statistical studies, a search of the literature is unrewarding. Cross-section studies of a sort are used extensively by security analysts to arrive at buy and sell recommendations. The values of certain attributes such as the dividend yield, growth in sales, and management ability are obtained and compared for two or more stocks. Then, by some weighting process, a conclusion is reached from this information that a stock is or is not an attractive buy at its current price.2 Graham and Dodd go so far as to state that stock prices should bear a specified relation to earnings and dividends, but they neither present nor cite data to support the generalization.3 The distinguished theoretical book on investment value by J. B. Williams contains several chapters devoted to the application of the theory, but his empirical work is in the tradition of the investment analyst's approach.4 The only study along the lines suggested here that is known to the writer is a recent one on bank stocks by David Durand.5 In contrast with the dearth of published studies the writer has encountered a number of unpublished cross-section regressions of stock prices on dividends, earnings, and sometimes other variables. In these the correlations were high, but the values of the regression coefficients and their variation among samples (different industries or different years) made the economic significance of the results so questionable that the investigators were persuaded to abandon their studies. There is reason to believe that the unsatisfactory nature of the findings is due in large measure to the inadequacy of the theory employed in interpreting the model, and it is hoped that this paper will contribute to a more effective use of cross-section stock price studies by presenting what might be called the elementary theory of the variation in stock prices with dividends and earnings. Before proceeding, it may be noted that there have been some time series studies of the variation in stock prices with dividends and other variables. The focus of these studies has been the relation between the stock market and the business cycle6 and the discovery of profitable * The research for this paper was supported by the Sloan Research Fund of the School of Industrial Management at Massachusetts Institute of Technology. The author has benefited from the advice of Professors Edwin Kuh, Eli Shapiro, and Gregory Chow. The computations were done in part at the M.I.T. Computation Center. 'Assume that the hypothesis stock price, P f (xi, X2,...), is stated so that it can be tested, and it is found to do a good job of explaining the variation in price among stocks. The model and its coefficients thereby shed light on what investors consider and the weight they give these variables in buying common stocks. This information is valuable to corporations insofar as the prices of their stocks influence their financial plans. It is also true that a stock selling at a price above or below that predicted by the model deserves special consideration by investors. 2 Illustrations of this method of analysis may be found in texts on investment analysis such as: Graham and Dodd, Security Analysis, 3rd ed. (New York, i95i); and Dowrie and Fuller, Investments (New York, I94I). ' Graham and Dodd, op. cit., 454 ff. 'The Theory of Investment Value (Cambridge, I938). 5Bank Stock Prices and the Bank Capital Problem, Occasional Paper 54, National Bureau of Economic Research (New York, I957). 'J. Tinbergen, "The Dynamics of Share-Price Formation," this REVIEW, XXi (November I939), 153-60; and Paul G. Darling, "A Surrogative Measure of Business Con-

1,141 citations

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TL;DR: The interest in capital equipment analysis that has been evident in the business literature of the past five years is the product of numerous social, economic, and business developments of the postwar period.

Abstract: The interest in capital equipment analysis that has been evident in the business literature of the past five years is the product of numerous social, economic, and business developments of the postwar period. No conclusive listing of these developments can be attempted here. However, four should be mentioned which are of particular importance in this search for a more systematic method for discovering, evaluating, and selecting investment opportunities. These are: (1) the high level of capital outlays (in absolute terms); (2) the growth in the size of business firms; (3) the delegation of responsibility for initiating recommendations from top management to the profit center, which has been part of the general movement toward decentralization; and (4) the growing use of “scientific management” in the operations of the business firm.

774 citations