What Is Bird In Hand Theory?
The Bird in Hand theory states that investors prefer dividends earned from equity instead of capital gains owing to the latter’s inherent uncertainty. Economists John Lintner and Myron Gordon developed this theory as a contradiction to the dividend irrelevance theory formulated by Modigliani and Miller.
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According to this theory, the stocks offering high dividend payouts appeal to investors. As a result, such securities‘ market price is higher than the other shares available. Lintner and Gordon suggested that the higher the capital gains/dividend ratio, the larger the overall return is necessary for investors owing to the increased risk.
Table of contents
Key Takeaways
- The bird in hand theory specifies that investors prefer to allocate their funds to dividend-paying stocks rather than stocks with the potential to generate capital gains because dividend income is more certain.
- Gordon and Lintner introduced this theory, also known as the dividend relevance theory.
- There are various assumptions of bird in hand theory. For example, corporations are not liable to pay corporate income taxes, and an organization’s capital structure includes only equity.
- There are multiple criticisms of the bird in hand theory. One of them is that dividend policy does not affect an organization’s cost of capital.
Bird In Hand Theory Explained
The bird in hand theory specifies that investors choose the certainty of receiving dividend payments over the possibility of earning significantly more capital gains. Also known as dividend relevance theory, it was developed as a response to the dividend irrelevance theory, which states that an investor does not care how the returns are generated.
According to Lintner and Gordon, investors consider future capital gains risky propositions and discount those gains at a rate higher than the company’s earnings, thus estimating a higher stock value. Moreover, the two economists claimed that a 1% decrease in a stock’s dividend payout must be offset by additional growth of over 1%.
This theory implies that an organization’s regular dividend payout policy impacts investors’ behavior and a stock’s price. It reasons that a business’s cost of capital increases owing to a low dividend payout. Investors believe more retained earnings can positively impact growth and increase future dividends. The higher dividend payout can, in turn, boost the stock price.
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Assumptions
The assumptions of bird in hand theory are as follows:
- A company’s capital structure comprises only equity and no debt.
- Corporations cannot obtain external financing. Hence, they must fund their development and expansion only by retaining their earnings.
- Companies do not have to pay any corporate income taxes.
- A corporation’s cost of capital remains constant. Moreover, it is higher than the growth rate.
- The retention ratio of a company is constant.
Examples
Let us look at a few bird in hand theory examples to understand the concept better.
Example #1
Suppose Jim Taylor is an investor who allocates funds to equity shares of different companies to generate returns and achieve his financial objectives. He prefers receiving dividend income from the stocks in his portfolio to earning capital gains by selling the shares. This is because he chooses the certainty of dividend payouts over the uncertainty associated with capital gains. This supports the bird in hand theory.
Example #2
As a high dividend yield stock, IBM Corp. is a stock that is ideal for individuals with an investment strategy based on the bird in hand theory. The company has rewarded its shareholders with dividend growth for over 26 years. As of 12, 2023, IBM stock offered a dividend yield of around 5%.
Criticisms
The criticisms of the bird in hand theory are as follows:
- Dividend policy has no impact on a company’s cost of capital.
- Investors are completely indifferent if they earn more capital gains or dividend income.
- Besides stating the above two points, Miller and Modigliani criticized the theory suggesting that investors reinvest their dividends in the same company or a similar organization and that business’s riskiness is only impacted by the cash flows generated from its operating assets.
Advantages
The benefits of following the bird in hand theory of dividends are as follows:
- It emphasizes allocating funds to dividend-paying stocks. One can consider dividend earnings safer and more certain than capital gains.
- Individuals can keep earning dividend income at regular intervals. On the other hand, capital gains are a one-time benefit.
- In specific unfavorable situations, when the market is severely impacted, dividend income becomes a more trustworthy income source than capital gains.
- Investors can estimate the dividend amount. However, one cannot do the same regarding capital gains.
Limitations
Let us look at some limitations of this theory.
- It assumes that a company’s dividend policy is stable and the business does not alter the dividend payouts over time. However, this assumption fails to consider the fact that organizations often decide to alter their dividend policy owing to any change in market conditions.
- The theory fails to consider the impact of inflation on dividends. With time, the cash dividend payments’ purchasing power decreases owing to inflation. As a result, this theory becomes less applicable.
- The theory assumes that the investors have a low risk appetite and prefer a specific amount of dividend payments to uncertain stock prices. That said, some investors have a high risk appetite. Therefore, rather than cash dividend payments, they prefer stocks offering high returns irrespective of their uncertain prices.
- According to this theory, investors choose cash dividends over stock dividends. That said, investors may want to receive stock dividends for tax or any other reason. This impacts this theory’s applicability.
Frequently Asked Questions (FAQs)
Lintner proposed this theory in 1956, while Walter presented it in 1963. It was supported by the dividend relevance theory developed by Myron Gordon in 1959.
There are different reasons why this theory is considered fallacious. Let us look at some of them.
– Investors often reinvest the dividends earned in the same or similar company.
– An organization’s dividend policy does not affect its cost of capital.
– The third criticism of this theory assumes that companies can reinvest the funds paid out as dividends at a high rate of return.
The tax preference theory states that investors prefer earning long-term capital gains to receiving dividend income. On the other hand, the bird in hand theory of dividends specifies that all investors want to earn dividend income rather than capital gains owing to the former’s certainty.
This theory’s name is based on the proverb, a bird in the hand is worth two in the bush.
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