Has Centrica's change in dividend policy cost them market value?

The proportion of profits a company pays to its shareholders is known as the dividend policy. In the UK, dividends are usually paid every 6 months in the form of an interim dividend for the first half years trading, followed by a final dividend at the year end. The dividend policy of a company should link with the overall objective of maximising shareholder wealth at every opportunity. It is argued by some that dividend policy should remain stable so shareholders know what to expect, making the flurry of news articles regarding the change in the dividend policy of Centrica an interesting read (Farrell, Kavanagh, Bloomberg, Financial Times & Patron. 2015). Centrica announced plans to cut their dividend for the first time since it was created in 1997. The large scale drop of 30% led to queries regarding what caused this sudden change in dividend policy and whether it maximised the wealth of shareholders.

Despite the argument that dividend policy is of importance to shareholders, this is not unanimous. Miller & Modigliani (1961) argued that if a few assumptions were made, including no transaction costs, no taxation and perfectly efficient markets, dividend policy is irrelevant to the value of shares. They claim share value is a result of corporate earnings, reflecting investment policy, rather than the amount of dividends paid. Consequently, investment policy is the only factor determining market value, implying value is independent of the dividend paid. Miller & Modigliani also claimed that rational investors are indifferent to whether they receive dividends or capital gains. The important factor is that a company maximises shareholder value through the adoption of an optimal investment policy, in which they invest in all projects with a positive NPV. Any remaining earnings can then be paid out as a dividend. If a shareholder wants a dividend and the company chooses not to pay one, they can create their own through the sale of shares.

According to this policy, Centrica’s market value would not be affected by the decision of the company to cut the dividend. This is not because they are 'not bothered' about receiving a dividend, but rather due to an indifference to the timing of the dividend. Shareholders would recognise appropriate investments had been made which would contribute to expected future dividends. However, this is not the case for the shareholders in Centrica, as share price fell by 8.3% following the announcement of the dividend cut. Critics of this theory would argue this is because in the real world taxation and transaction costs do exist; making dividend policy much more complex and disputable. 

Contrastingly, the traditional view argues dividend policies do influence share valuations (Lintner 1956, Gordon 1959). This approach believes shareholders prefer a certain dividend to be paid now rather than receiving the equivalent value through an investment with uncertain future value. Hence, dividends are considered more reliable than capital gains. This would explain the drop in Centrica’s share price following the dividend cut; shareholders perceive the cut as a return with much less guarantee.

Clientele effect goes some way to explain this, proposing that shareholders prefer a dividend pattern which matches their desired consumption pattern. Some clientele may not be interested in receiving dividends in the short term, and vice versa. This implies companies should aim to provide a stable and consistent dividend so investors know the investment will suit their preferences. This is apparent in the case of Centrica who, as a utility that has never lowered its dividend up until this point, has become popular with investors looking for a high dividend income. It therefore seems rational to suggest some shareholders in Centrica will have purchased the shares at least partly because the dividend policy suits them, putting pressure on Centrica to maintain a stable, consistently high dividend. The graph below demonstrates the extent of the change in dividend policy by Centrica. Total dividends per share have historically increased continuously, no doubt reinforcing the shock of the dividend cut. The cut threatened Centrica’s status as one of the FTSE 100’s highest yielding stocks, strengthening the argument shareholders in Centrica expect large dividends.

Made by blog author
Data obtained from Centrica (2014)

Another potential explanation for the drop in share price after Centrica announced its dividend cut is the belief that dividends convey information about the future of a company. An unexpected decline in the dividend, as is the case with Centrica, may signal a pessimistic view of the future. Shareholders may become uneasy and, due to a lack of other information, lose confidence in the company. Despite Centrica providing an explanation for the dividend cut, stating it is necessary for the continued success of the business, it would appear shareholders are not keeping this in mind. Investors often tend to have a short sighted view of the market; thus, are not taking the potentially positive future results from the dividend cut.

Ultimately, I believe it is clear clientele effect has played some role in reactions of Centrica’s shareholders; lending support to the traditional view of dividend policy. Having gained a reputation as one of the FTSE 100’s highest yielding stocks, it is apparent investors have come to expect this which is likely to have played some role in the decision to purchase shares in Centrica.  Upon the announcement of a dividend cut, share price dropped as the dividend policy was no longer stable. This exposed shareholders to potentially volatile dividends which were unlikely to meet their particular requirements. Consequently, the confidence shareholders have in Centrica is likely to have started declining.


References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Baker, H., Powell, G. & Veit, E. (2002). Revisiting the dividend puzzle: Do all of the pieces now fit?, Review of Financial Economics, 11(4), 241-261. doi: 10.1016/S1058-3300(02)00044-7

Bloomberg. (2015). Centrica slumps most since 2008 after cuts dividend on loss. Retrieved 9^th March 2015, from http://www.bloomberg.com/news/articles/2015-02-19/centrica-cuts-dividend-after-posting-1-6-billion-full-year-loss

Centrica, (2014). Annual Report. Retrieved 9th March 2015, from http://www.centrica.com/files/reports/2014ar/Centrica_AR2014_Annual_Report.pdf

Farrell, S. (2015). Centrica slashes dividend after annual profit falls. Retrieved 9^th March 2015, from http://www.theguardian.com/business/2015/feb/19/centrica-slashes-dividend-after-annual-profit-falls

Financial Times. (2015). Centrica: upstream without a paddle. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/3/d943a040-b840-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Gordon, M. (1962). The Savings Investment and Valuation of a Corporation, The Review of Economics and Statistics, 44(1), 37-51. doi: 10.2307/1926621

Kavanagh, M. (2015). Centrica slashes dividend as losses bite. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/0/83d6d11a-b80c-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Linter, J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes. The American Economic Review, 46(2), 97-113. Retrieved from JSTOR http://www.jstor.org/

Miller, M. & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares, The Journal of Business, 34(4), 411-433. Retrieved from JSTOR http://www.jstor.org/

Patron, E. (2015). Centrica: What the analysts say. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/0/c603dfea-b822-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.