[BETA] Fortnightly

Will dividends become the sole focus for investor valuations of utilities?

With last month's favorable Senate vote to repeal the tax on dividends from 2004-2006 and reduce it 50 percent this year, and the high-profile conference committee meetings between the House and the Senate at press time, many are asking if investors are, or should be, beginning to evaluate utility companies solely on the basis of the dividend.

Paul Patterson, an analyst with Glenrock Associates, in a report titled Dividend Yield: Implications for Value & Capital, outlines some of the issues surrounding the increased focus on the dividend. While he believes that the dividend tax repeal would be positive for utility valuations, he does not believe that investors will rely solely on the dividend in stock value determination. Rather, the dividend will be viewed as only one factor among many.

Patterson does not believe that the dividend discount model (DDM) should be used as the sole means of determining a given stock's value. In the report, Patterson evaluates the DDM and finds several reasons why investors should be cautious in relying solely on DDM. Patterson believes that DDM fails in situations where there is a great deal of uncertainty as to the future growth, or lack thereof, of a company.

In addition, Patterson says it is not clear that "most investors value stocks solely on the expectation of dividend payments, however rational this viewpoint may be. Although, in theory, the DDM model can even apply to 'growth' companies not yet paying dividends, we do not believe that all market participants view dividends as the sole source of value that they expect a stock to provide." Not to mention that the DDM's model calls for a "relatively complex calculation using a set of factors projected into the future" that will "likely only be used reticently, if at all, by investors," Patterson says. In the report, he explores alternatives to the DDM as a means of incorporating yield in valuing companies.

Moreover, Patterson says the new emphasis on the dividend could change the way companies allocate their capital. "The increased preference for dividends could cause companies to focus less on redeploying capital into 'growth investments' and more into relatively 'safe' investments. Specifically, it could reinforce a tendency toward risk aversion. … [If] favorable tax treatment of dividends were to be implemented in some way, we think this could further enhance this trend."

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