Bird in Hand: What is it?

Investors enter the stock market with a set of objectives and investment strategies. Some of them want regular income, whereas others want to have a quadruple gain on their investment. Some Investors may consider the tax effect and make investment decisions accordingly. Investors’ preference over other things can have a significant impact on the stock price. After all, one of the factors driving stock price is investor perception.

Based on the investors' perception of dividends as a return from a stock, various economists and professors proposed different dividend theories. One of these dividend theories is the bird in hand theory.

This article highlights bird in hand meaning, formula, advantages, and examples of bird in hand in the share market

Bird in Hand Definition

There is a saying that “a bird in the hand is worth two in the bush”. This saying emphasizes the significance of present and definite benefits over future and uncertain benefits. In the stock market, the stock dividend is the ‘bird in the hand’, whereas capital gain is the ‘two in the bush’. The bird in hand theory believes that irrespective of what the investor’s hand receives, even if it is lesser, is better than the risk of losing more by looking to get more. Therefore, the theory argues that investors would prefer, due to the higher certainty, dividends over the capital gain from investments.

The reason behind the emphasis on dividends is the uncertainty associated with a capital gain. Capital gain refers to the profit incurred from selling the stock. When capital gain has a much bigger potential than dividends, it can also be zero or negative. An investor cannot accurately predict the capital gain. Moreover, plenty of the factors affect capital gain, and some of them are not even in the hands of investors.

Other than the bird in hand theory, there exist two more dividend theories. One is the dividend irrelevance theory, developed by Modigliani Miller and another is the tax preference theory. Dividend irrelevance theory argues that the investor behaviour does not change based on how they get the return, or whether they are paid a dividend or not. They are more concerned with an overall return.

On the other hand, tax preference theory states that investors consider tax treatment before making an investment decision. You get dividends at regular intervals, whereas you acquire capital gain only when the stock is sold. Moreover, dividends are taxed at a higher rate than capital gain. Therefore, this theory argues that investors are more concerned with capital gain than receiving dividends.

As a counterargument to dividend irrelevance theory, Myron Gordon and John Linter developed the bird in hand theory. It can also be called dividend relevance theory. Bird in hand theory states that the dividend decision of the firm affects investors’ behaviour and stock price.

The theory also states that the larger the weightage of capital gain in the total return, the higher the investor’s required rate of return. If the dividend falls by 1%, investors would require a corresponding increase of 1% in capital gain.

Formula

To make it evident that dividend impacts the stock price, Gordon gave a formula. The formula helps to arrive at the intrinsic value of the stock based on dividends paid. The formula is made up of three variables, namely, the annual dividend per share for 1 year, the expected annual return on investment, and expected dividend growth.

Intrinsic stock value = Annual dividend per share for year 1 / ( expected annual return on investment - expected dividend growth)

The formula makes it clear that the higher the annual dividend per share, and the expected dividend growth, the more the intrinsic value of a stock, and vice versa.

Assumptions

Certain assumptions under bird in hand theory include:

  • The company is using only equity financing, not debt funds.
  • Retained earnings are the only source of finance available to the company.
  • The company is retaining its earnings at a constant rate. In other words, the dividend payout ratio is constant.
  • The growth rate of earnings is constant.
  • The cost of capital is constant and higher than the growth rate.
  • No corporate taxes exist.

Advantages of Bird In Hand

The Bird in hand theory offers the following advantages.

  • The bird in hand theory emphasizes investing in the dividend-paying stock. Dividend income can be considered more certain and safer than capital gain.
  • Dividends are the present benefit. Investors keep getting dividends at regular intervals. Capital gain is a one-time benefit that is extended to the future.
  • An investor can estimate the amount of dividend, which can not be done in the case of capital gain. Exact capital gain is unpredictable, before the selling of the stock.
  • In certain unfavourable instances, when the entire market suffers from losses, dividend income is a more trustworthy source of income against capital gain.

Example of Bird In Hand

  1. One of the examples of a bird in hand is Coca-Cola. The company came up with an IPO in 1919 and has been paying dividends every quar
  2. McDonald's, an Aristocrat of the S&P 500, is another such stock rewarding the investors with dividends regularly. An ‘Aristocrat’ means the stock which has paid and increased dividends for at least 25 cumulative years.
  3. Pepsico, a beverage giant, is also an example of a dividend-paying stock. The company increased its dividend for the 50th consecutive year, in 2022. Pepsico is considered the dividend king.
  4. In India, Oracle Financial Services Software Ltd., Shree cement Ltd., Hero MotoCorp Ltd., Hawkins Cookers Ltd., etc. are some of the stocks that have increased dividends and surpassed nifty 50’s annualized return over the past 20 years ending March 31, 2021.

The bird in hand dividend theory states that a dividend decision is relevant to the investors’ behaviour. Investors would prefer certain and near-term benefits i.e. dividend income over uncertain and future benefits i.e. capital gain. Though similar to other theories, this theory has weak points, too. The assumptions are not practically possible. Moreover, not all investors prefer dividends over capital gains, as capital gains surpass the dividend over the long run. However, investors looking for regular income would prefer stocks paying dividends at increasing rates.

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Frequently Asked Questions Expand All

Ans. Coca-cola, McDonald’s, and Pepsico are some of the companies that regularly pay dividends and can be considered examples of Bird in Hand theory.

Ans. Investing in the stocks that pay dividends for years is a ‘bird in the hand’, whereas capital gain investing is ‘two in the bush’ part of the saying “a bird in the hand is worth two in the bush”. Bird in hand theory believes that investors prefer to invest in dividend-paying stocks, as the dividend incomes are more certain. Capital gains investing means investing in those stocks which have a higher potential to grow in prices, and thereby provide larger gains.

Ans. Bird in hand theory is important for investors as it implies that what is in your hand, even if it is lesser, is better than the risk of losing more by looking to get more. The capital gain can be larger than dividend payments, though, it can be zero or negative, too. Dividend incomes are lower but more certain. Thus, the bird in hand theory states that stock dividends are more likely to be preferred by investors over capital gains.