reserves. Great investors, such as Benjamin Graham, made some of their
most profitable trades by purchasing shares in such companies and then
convincing management (sometimes tactfully, sometimes with a threat
of takeover) to disgorge its liquid assets.^8
One might question why management would not employ assets in
a way to maximize shareholder value since managers often hold a large
equity stake in the firm. The reason is that a conflict often exists between
the goal of the shareholders, which is solely to increase the return on
their shares, and the goals of management, which may include prestige,
control of markets, and other objectives. Economists recognize the con-
flicts between the goals of managers and shareholders as agency costs,
and these costs are inherent in every corporate structure where owner-
ship is separated from management. Payment of cash dividends or com-
mitted share repurchases often lowers management’s temptation to
pursue goals that do not maximize shareholder value.
Finally, capital expenditures are certainly necessary in a growing
firm, yet many studies show that firms often overexpand and spend too
much on capital, which reduces profits and forces retrenchment by man-
agement.^9 Often young, fast-growing companies may create more value
by spending on capital expenditures, while companies in older, more
mature industries, in which agency costs are most severe, pay dividends
or repurchase shares, which is better for shareholders.
The Value of Stock as Related to Dividend Policy
Management determines its dividend policy by evaluating many factors
including the tax impact on shareholders; the need to generate internal
funds to retire debt, invest, or repurchase shares; and the desire to main-
tain a stable dividend level in the face of fluctuating earnings. Since the
price of a stock depends primarily on the present discounted value of all
expected future dividends, it appears that dividend policy is crucial to
determining the value of the stock.
But as long as one specific condition holds—that the firm earns the
same return on its retained earnings as shareholders demand on its stock—then
future dividend policy does not impact the market value of the firm.
This is because dividends not paid today become retained earnings that
100 PART 2 Valuation, Style Investing, and Global Markets
(^8) Benjamin Graham and Seymour Chatman (ed.), Benjamin Graham: The Memoirs of the Dean of Wall
Street, New York: McGraw-Hill, 1996, Chap. 11.
(^9) See Jeremy Siegel, “Capital Pigs,” The Future for Investors: Why the Tried and the True Triumph over the
Bold and the New, New York: Crown Business, 2005, Chap. 7.