Are Dividends the Foundation?

When valuing bonds and preferred stock, we determined the discounted value of all the cash distributions made by the firm to the investor. In a similar fashion, the value of a share of common stock can be viewed as the discounted value of all expected cash dividends provided by the issuing firm until the end of time. This seems consistent with what we have been doing so far.

This assumes that investors will be willing to buy our stock two years from now. In turn, these future investors will base their judgments of what the stock is worth on expectations of future dividends and a future selling price (or terminal value). And so the process goes through successive investors.

Note that it is the expectation of future dividends and a future selling price, which itself is based on expected future dividends, that gives value to the stock. Cash dividends are all that stockholders, as a whole, receive from the issuing company. Consequently, the foundation for the valuation of common stock must be dividends. These are construed broadly to mean any cash distribution to shareholders, including share repurchases. (See Chapter 18 for a discussion of share repurchase as part of the overall dividend decision.)

The logical question to raise at this time is: Why do the stocks of companies that pay no dividends have positive, often quite high, values? The answer is that investors expect to sell the stock in the future at a price higher than they paid for it. Instead of dividend income plus a terminal value, they rely only on the terminal value. In turn, terminal value depends on the expectations of the marketplace viewed from this terminal point. The ultimate expectation is that the firm will eventually pay dividends, either regular or liquidating, and that future investors will receive a company-provided cash return on their investment. In the interim, investors are content with the expectation that they will be able to sell their stock at a subsequent time, because there will be a market for it. In the meantime, the company is reinvesting earnings and, everyone hopes, enhancing its future earning power and ultimate dividends.