Clientele Theory of Dividends


Clientele theory deals with the relationship of types of investors to stock prices and dividends. The basic thesis is that since dividends are personal income, and thus involve higher taxes than capital gains, the types of clientele that are attracted to firms might be related to whether dividends are considered high or low. This thesis remains highly controversial.


Types of clients are generally divided into institutional buyers and personal investors. The assumption is that personal income taxes (affecting the latter) are higher than what institutions pay. Therefore, the nature of dividends is a relevant variable because high dividends often equals high risk, and since so much of that income is taxed anyway, it is not a risk that many personal investors are willing to take. This, of course, affects stock prices. However, if an individual sees stock values fall, they will sell, taking this as a windfall since capital gains rates are lower than individual income tax rates.


A simpler way to put this is to say that stock prices vary according to the demands and interests of the different types of investors. One way to explain this is to hold that investors with a low risk tolerance will not gravitate to high-dividend-yielding stock, especially if they are individuals who then must pay a relatively high personal income tax rate on this income. Therefore, these types of dividends are more attractive to institutions such as banks or mutual funds that can deal with more risk.


The clientele effect is that investors are concerned about company policy. If a high-yielding stock (owned by an individual) becomes an only moderately yielding stock, then some will sell it on the theory that recording this stock as capital gains is more in their interest than continuing to pay income tax on dividends. This then affects the stock price. This version of the theory holds that sales to make a capital gain are in the interest of individual investors since capital gains taxes are lower than personal income taxes. In a certain way, selling stock that begins to pay lower dividends is a hedge against the lowering of the stock value in general.


The purpose of this theory is to predict the decisions of investors. This will then affect the financial decisions of the firm. The firm selling stock begins with the concept that certain buyers (individual investors) are tax disadvantaged. This just means that they pay higher personal income tax rates than do institutions. Therefore, individuals, all other things being equal, will avoid high-yielding firms. High-yield firms will attract those with tax advantages such as other firms or funds. The final theorem is that institutional investors will be more attracted to high-yield stocks than personal investors.


Understanding investor behavior relative to the type of investor is centrally important to firm management. From the point of view of the firm that issues stock, institutional investment is more stable than individual investment. This might suggest that keeping dividends high will attract the type of institutional investment they want, while keeping the â??causalâ? investor away.

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