Traditional Position

The traditional approach to the dividend policy, which was given by B.Graham and D.L.Dodd lays a clear emphasis on the relationship between the dividends and the stock market. According to this approach, the stock value responds positively to higher dividends and negatively when there are low dividends.

The following expression, given by traditional approach, establishes the relationship between market price and dividends using a multiplier: –

P          =          m (D+ E / 3 )

Where,

P = Market price

m = Multiplier

D = Dividend per share

E = Earning per share

Limitation of the Traditional Approach

The traditional approach, further states that the P/E ratios are directly related to the dividend payout ratio i.e., a high dividend payout ratio will increase the P / E ratio and vice-versa. However, this may not be true in all situations. A firm’s share price may rise even in case of a low payout ratio, if the earnings are increasing. Here the capital gains for the investor will be higher than the cash dividends. Similarly for a firm having a high dividend payout ratio with a slow growth rate there will be a negative impact on the market price (because of lower earnings). In addition to this there may be a few investors of the company who would prefer the dividends to the uncertain capital gains and few who would prefer taxed capital gains. These conflicting factors that have not been properly explained from the major shortcomings of the dividend policy given by the traditional approach. These can be summarized as

• P/E ratios are directly related to the dividend payout ratios is not true for a firm’s whose payout is low but its earnings are increasing.
• This approach does not hold good for those firm whose payout is high but have slow growth rate.
• There may be few investors who would prefer the dividends to the uncertain capital gains and a few who would prefer low taxed capital gains.
• These conflicting factors have not been properly explained by traditional approach.