What is the Dividend Irrelevance Theory
The dividend irrelevance theory is the theory that investors do not need to concern themselves with a company's dividend policy since they have the option to sell a portion of their portfolio of equities if they want cash.
Understanding Dividend Irrelevance Theory
The dividend irrelevance theory indicates that a company’s declaration and payment of dividends should have little to no impact on stock price. If this theory holds true, it would mean that dividends do not add value to a company’s stock price.
Yet studies show that stocks that do pay a dividend, like many blue chip stocks, often increase in price by the amount of the dividend as the book closure date approaches. Although the dividend may not actually be paid until a few days after this date, given the logistics of processing such a large number of payments, the price of the stock usually drops again the amount of the dividend. Buyers after this date are no longer entitled to the dividend. These practical examples can conflict with the dividend irrelevance theory.
Analysts conduct valuation exercises to determine a stock’s intrinsic value. These often incorporate factors, such as dividend payments, along with financial performance, and qualitative measurements, including management quality, economic factors, and an understanding of the company’s position in the industry.
Dividend Irrelevance Theory and Portfolio Strategies
Despite the dividend irrelevance theory many investors focus on dividends when managing their portfolios. For example, a current income strategy seeks to identify investments that pay above average distributions (i.e., dividends and interest payments). While relatively risk-averse overall, current income strategies can be included in a range of allocation decisions across a gradient of risk.
Strategies focused on income are usually appropriate for investors in need of stable, established entities that will pay consistently (i.e. without risk of default or missing a dividend payment deadline). These investors might be older and/or willing to take on fewer risks. Dividends may feature in a range of other portfolio strategies, as well, such as preservation of capital.
Blue chip companies generally pay steady dividends. These are multinational firms that have been in operation for a number of years, including Coca-Cola, Disney, PepsiCo, Walmart, IBM, and McDonald’s. These companies are dominant leaders in their respective industries. and have built highly reputable brands, surviving multiple downturns in the economy.