How does Walter formula of dividend distribution help in understanding the dividend policies?

Answer 1

The term dividend refers to that part of after-tax profit which is distributed to the owners (shareholders) of the company. The undistributed part of the profit is known as Retained earnings. Higher the dividend payout, lower will be retained earnings.

The dividend policy of a company refers to the views and policies of the management with respect of distribution of dividends. The dividend policy of a company should aim at shareholder-wealth maximization.

The essence of dividend policy is:

If the company is confident of generating more than market returns then only it should retain higher profits and pay less as dividends (or pay no dividends at all), as the shareholders can expect higher share prices based on higher RoI of the company. However, if the company is not confident of generating more than market returns, it should pay out more dividends (or 100% dividends). This is done for two reasons. One, the shareholders prefer early receipt of cash (liquidity preference theory) and second, the shareholders can invest this cash to generate more returns (since market returns are expected to be higher than returns generated by the company).

Over the years, various models have been developed that establish the relationship between dividends and stock prices. The most important of them is Walter Model:

Walter Model

Prof James E. Walter devised an easy and simple formula to show how dividend can be used to maximize the wealth position of shareholders. He considers dividend as one of the important factors determining the market valuation. According to Walter, in the long run, share prices reflect the present value of future stream of dividends. Retained earnings influence stock prices only through their effect on further dividends.

Assumptions:

The company is a going concern with perpetual life span.

The only source of finance is retained earnings. i.e. no other alternative means of financing.

The cost of capital and return on investment are constant throughout the life of the company.

According to Walter Model,

P = [D + (E - D) x ROI / Kc] / Kc

P= Market price per share E= Earnings per share

D = Dividend per share Kc= Cost of Capital (Capitalization rate)

ROI = Return on Investment (also called return on internal retention)

The model considers internal rate of return (IRR), market Capitalizatio rate (Kc) and dividend payout ratio in determination of share prices. However, it ignores various other factors determining the share prices. It fails to appropriately calculate prices of companies that resort to external sources of finance. Further, the assumption of constant cost of capital and constant return are unrealistic.

If the internal rate of return from retained earnings (RoI) is higher than the market capitalization rate, the value of ordinary shares would be high even if the dividends are low. However, if the RoI within the business is lower than what market expects, the value of shares would be low. In such cases, the shareholders would expect a higher dividend.

If RoI > Kc, Price would be high even if Dividends are low

Walter model explains why market prices of shares of growth companies are high even if dividend payout is low. It also explains why the market prices of shares of certain companies which pay higher dividend and retain low profits are high.

Example:

A Ltd. paid a dividend of Rs 5 per share for 2009-10. the company follows a fixed dividend payout ratio of 30% and earns a return of 18% on its investments. Cost of capital is 12%. The expected price of the shares of A Ltd. using Walter Model would be calculated as follows

EPS = Dividend / payout Ratio = 5 / 0.30 = Rs.16.67

According to Walter Model,

P = [D + (E - D) x ROI / Kc] / Kc

P = [5 + 16.67 - 5.00) x 0.18 / 0.12] / 0.12

P = 187.50