When using a DDM, what happens to the intrinsic value of a stock when a firm cuts its dividend payout ratio? I know that the market price will drop because this is perceived as bad news, but the effect on the intrinsic value is confusing to me. If the dividend payout ratio decreases, g will increase which increases the intrinsic value. On the other hand, if the dividend payout ratio decreases, dividends will decrease which decreases the intrinsic value. Thus, I don’t understand what will be the overall effect on the intrinsic value.
Assuming the simplest case of a DDM with a constant growth rate you find for the value at the beginning of period one: Value1 = E0 * PR * (1+g) / (r-g) where r is the required return, g the growth rate, PR the payout ration and E0 the earnings in period zero.
Now you can use the sustainable growth rate g = ROE * (1 - PR) and put it into your formula to find:
You can immediately note that for PR = 0 you have Value1 = 0 (if you never get a payout it is worth nothing in the DDM) and for PR = 1 you find Value1 = E0 / r (this is the zero growth case). Now you need to fill the voids between those extremes. There are a couple of ways to proceed, the easiest is certainly to plot the result for a couple of different r and ROE (assuming E0 constant): So for ROE = 0.15 and r = 0.20 you find that the value is a monotonously increasing function of PR (see this graph, which shows Value as a function of payout ratio). I am sure you can prove that this is the case for any sensible combination of variables and only breaks down if you make strange assumptions (e.g. ROE > r).
This result is to be expected, because as long as ROE < r the investor should prefer to get all the cash from the business in form of dividends and invest it at his required rate of return rather than have the business reinvest that cash at ROE (< required rate). So from the investors point of view you prefer PR = 1 if ROE < r.