REWARDING FUNDS SUPPLIERS

GoalsFinancial AnalysisForecastAsset SelectionCapital Structurehome

Useful Web sites

Dividend Theory

There are as many theories regarding the proper level of dividends as dividend payers and payees! One of the great mysteries in finance, though not from lack of effort by theoreticians and researchers, is the lack of a definitive algorithm regarding the role of dividends in the valuation of corporate equities. There are three major schools of thought, with many variations, which seem to dominate the current view of dividend policy:

  1. High dividends result in higher stock prices
  2. Low dividends indicate high growth potential and higher equity valuations
  3. It doesn't really matter in the long run

The high dividend believers basically take the "bird in the hand beats a larger bird in the bush" position by correctly observing that receiving a cash dividend check provides proof that the company is financially able to pay dividends and that management has not forgotten who owns the firm. A famous investment text written over 40 years ago was a strong proponent of high cash dividends and many investors remain influenced by this material. The authors made the point that long term investors buy stock in quality companies and do not make frequent trades. Therefore, the only means to reward them for their ownership is to pay a cash dividend which they can choose to either consume or reinvest in new shares. Additionally, investors are assumed to be long term risk averse and a cash dividend check in the hand is much less risky than a potential capital gain arising from growth through reinvested earnings. Lower risks should equate with higher stock valuations according to this approach.

An alternative perspective on the high dividend policy is that it may tell the world that the firm is running out of attractive growth opportunities that would require substantial new capital investments. This would indicate that as firms reach maturity and growth stabilizes, they should pay higher dividends since those funds are no longer needed to finance asset expansion. Not paying the higher dividend would provide management with unneeded funds which they might be tempted to squander on either managerial perks or 'pet' projects that do not have underlying economic value. The higher dividend thus becomes a form of discipline that prevents inappropriate use of free cash flow defined as cash flows less attractive investments.

top

The low dividend approach is basically a tax based argument which is being somewhat modified in light of current U.S. tax laws regarding dividend income. Since markets are considered to be reasonably efficient, it is unlikely that an individual investor can consistently outperform the corporation in terms of return on investment without accepting higher risks. Since dividend income is taxed at the personal level, there is less after tax income remaining to be invested so it becomes attractive to investors to have the firm retain the funds and invest them in new assets since the entire sum of earnings is available for investment. For example, an investor earns $1.00 in income per share and is in a 30% tax bracket. Assuming the firm can reinvest the earnings at 10% if it retains the entire sum, the shareholder expects to gain $.10 on every dollar earned and retained by the firm. If the $1.00 were paid out as a dividend, only $.70 would be available after tax for investment in new opportunities. In order to earn the same $.10 earned on retained earnings, the shareholder would have to find a 14.3% investment opportunity with identical risk as the firm's 10% opportunity. Efficient market theory would indicate that this is not possible over the long haul so presumably investors would reward firms that do not pay dividends with higher valuations than those paying them.

The low dividend approach had a large number of adherents during the bull market in the latter part of the 1990's when unlimited growth opportunities seemed to be available and firms would retain all of their earnings in order to pursue those opportunities. There was a period of time during which dividend paying firms were denounced as being stagnant or lacking in growth opportunities and their share valuations were noticeably lower than those of similar non-dividend paying firms. A few months into the new millenium and the attitude seemed to do an about face and suddenly dividend paying firms were being sought out by investors and rewarded with higher share valuations.

The doesn't matter group is largely following theory proposed by Franco Modigliani and Merton Miller (M&M), Nobel prize winning academicians, who observed that equity valuation is driven by the cash flows generated by firm assets rather than whether those cash flows are paid out as a dividend or retained for future investment. If the value of the firm is based on the present value of its future cash flows (generated by the assets held) at a reasonable return for the risks being assumed, why would the shareholder care whether they received their share of this value in the form of a cash dividend or as an increase in their stock price? If the shareholders have identical value whether they receive their reward in the form of cash dividends (a distribution of firm assets) or in the form of share price ( they can sell a few shares if they desire cash income), then dividend policy is irrelevant. The premise is based on some assumptions regarding no taxes and no brokerage costs, but the recent change in tax law regarding dividend income and the dramatically reduced costs of transactions in the market makes it difficult to dismiss this theory.

top

Sticky Dividends

An additional issue in U.S. dividend policy is our tradition of sticky dividends wherein firms pay out a relatively consistent and generally rising amount of dividends in the form of specific dollar amounts. They are considered "sticky" in the sense that once begun, it is difficult to lower the dividend without sending a signal of impending doom. Much of this tradition comes from the remnants of the Great Depression when a few firms were able to maintain their dividends throughout that difficult period and were rewarded by much higher stock price valuations than those forced to eliminate the dividend due to economic conditions. You can still find comments in annual reports that "we have consistently paid a dividend for the last 75 years" which becomes a constraint on new management. No one seems to want the elimination or reduction of the dividend to occur on their watch thus the observation that our dividends are somewhat sticky. You can easily find firms that either increase debt levels or sell new equity shares during the same time period they are paying dividends. They are, in effect, borrowing the money to pay the dividend or enduring the flotation costs of new equity in order to keep up the steady payment of those dividends.

An inevitable result is that dividend payouts as a percentage of income earned tends to fluctuate over time as income levels vary and dividends remain stable. The managerial concern becomes one of setting dividends sufficiently low as to ensure they will be less than any likely earnings per share regardless of future events. Thus, we have a policy of stable dollar dividends with fluctuating payout percentages. Contrast this with other countries where the dividend payout percentage is kept relatively constant, but the "dollar" dividends received each year will vary depending on the income for that year. In many respects, this is more representative of being an owner; you have good years and bad years depending on the macro economic situation and competition faced, but you can count on receiving your percentage of whatever was earned. Thus, many foreign firms have stable payout percentages, but varying "dollar" amounts depending upon the earnings for the period.

top

Residual Dividend Policy

From a financial economics point of view, there is a lot to be said for a residual dividend policy wherein the dividend received each period is exactly as the label implies; it is the residual or left over amount after all acceptable investments have been funded. The cash flow for the period is compared first to the list of available positive net present value projects. Projects are accepted to the point where the next project would either have a negative NPV or a rate of return below the cost of capital. Any cash flow remaining after these investments are made is then paid out to the shareholder as a dividend on the grounds that it is not needed by the firm to purchase assets and shareholders should receive the funds so they can pursue alternative investments. The difficulty with this approach is that the annual dividends received would fluctuate depending on both the cash flow for the period and on the set of potential investments available to the firm. Presumably, a shareholder could receive no dividend in a year when cash flows are insufficient to pay for all worthwhile investments or might see a dividend equal to the entire year's cash flow when there are no appropriate investment opportunities for the firm. Our sticky dividend tradition would not find such fluctuations attractive. Instead, it appears most firms adopt a variant of the residual dividend policy wherein they attempt a long term estimate of likely capital expenditure needs and probable cash flows. Annual dividends are then set based on the predicted long term residual difference between cash flows and asset funding requirements.

For example, look at the forecasted cash flows, investment opportunities and resultant dividends below:

 

After-Tax Cash Flows

Investment Opportunities
Strict Residual
Smooth Residual
1
$500,000
$250,000
$250,000
$150,000
2
$350,000
$400,000
0
$150,000
3
$700,000
$350,000
$350,000
$150,000
4
$600,000
$300,000
$300,000
$150,000
5
$300,000
$400,000
0
$150,000
Total
$2,450,000
$1,700,000
$900,000
$750,000

A couple of points worth noting: 1) notice that the shareholder receives less in total under the smooth residual policy since the firm is simply averaging the difference between total cash inflows and total investment opportunities over the five year span. Under the strict residual policy, the firm pays nothing when it needs all of the after-tax cash flow but cannot ask for a return of previous dividends that perhaps should not have been paid. In the smooth residual mode, the shareholder is trading off stability versus less total funds received. The firm anticipates that there will be periods when it needs more than is available so is saving for future outflows or replenishing the reserve fund as appropriate, but it does not spend more than it estimates will be available over future periods.

It is more likely than not that management will err on the conservative side to avoid facing significant dividend payouts (remember the sticky problem) when funds are needed to provide financing for new assets. The resulting average annual residual is announced and paid out as a stable dividend across time. While this approach solves the fluctuation problem associated with a residual dividend policy, it is likely to result in a low dividend payout percentage since management will not risk being forced to reduce the dividend should cash flows be less than estimated or capital expenditure requirements be higher. In effect, they will hold back a "slush fund" each year to smooth out the inevitable fluctuations of an uncertain future. The question then becomes one of justifying not paying out funds for which there is no profitable immediate opportunity!

top

Signal and Clientele Effects

There is a concern with the role dividend policy may play in providing information or "signals" about the company and its likely future prospects. We have already addressed the reality that dividends tend to be sticky and reducing them is often interpreted as a sign of failure likely to be followed by a reorganization in bankruptcy announcement. It is obvious that reducing dividends, in our economy, could be easily misinterpreted as a signal from management that future prospects appear bleak at best. On the other side, announcing a dividend increase might be interpreted as an affirmation that management, who presumably should be "in the know" about such things, has confidence in the long run earning power and cash flow from the firm's assets. The difficulty is two fold: First, the market knows that false signals are a real possibility so will tend to be cynical about announcements until the evidence is in over time. Dividends changes are real and tend to carry greater weight than simply another managerial announcement that "we foresee an improvement in operating performance in the future". Second, signals are often "20/20 hindsight" in that they only become clear after the opportunity to exploit them has passed. For example, a company has a remarkable opportunity to invest in an outstanding new product or market, but must forego paying a dividend in order to have the funds to pursue the new opportunity. Both the dividend reduction and the new opportunity are announced simultaneously. Which signal are you going to follow and why?.

The clientele effect relates to the fact that shareholders tend to invest in firms whose operating and dividend policies meet their own unique needs. Thus, a university endowment fund might choose investments with substantial annual cash income in lieu of opportunity for future price gains. Managers of these foundations tend to face frequent employment turnover since the constituency is often difficult to satisfy and tends to make their opinions available to governing boards. As a result, many endowment fund managers tend to focus on short term income measures rather than holding out for potentially greater long term capital gains. These organizations would tend to seek equity investments that pay significant cash dividends since they are in a low or no tax situation and want to maximize current income.

A young person with a self directed IRA, on the other hand, is probably thinking long term and does not look to the investment pool for current consumption needs. Indeed, they seek to minimize and/or delay taxes in hopes of achieving higher capital gains over time. This investor might tend to prefer firms that pay little or no dividends since they would prefer to gain in other ways.

Both parties can be satisified in a relatively efficient and broad market by seeking shares of firms whose dividend policy matches best with their needs or preferences. The firm, therefore, has a clientele that likes the way things are currently operating and who may, in the event of a change, choose to sell their shares and invest elsewhere. It does not say that either party is wrong or should be convinced to change, but an efficient capital market lets us make these choices. The only real concern for the firm is that existing shareholders have indicated a preference for or acceptance of current policies and practices. Change them only when you are inclined to take risks and deal with the consequences.

top

Alternative Dividend Payments

One of the currently popular approaches to the distribution of income to shareholders is the repurchase of stock using funds that would otherwise be paid out in the form of dividends. This approach receives significant publicity during sharp overall market downturns when a company will annouce it is buying back its own shares due to their being undervalued by the market. There is some evidence that these announcements are rarely completed since the company is creating an artificially high demand for the stock which will result in a higher price at which point it is no longer undervalued. The firm then quietly ceases to repurchase its shares before investing the entire sum of money initially announced. Shareholders who either tender their shares at the offered price or who sell in the open market will hopefully realize a capital gain which would be taxed at a rate below ordinary income tax rates on dividend income. Of course, an adherent to rational market theory will make the observation that this gain is already factored into the price offered for the shares during the buyback so the selling shareholder would neither gain nor lose relative to receiving the same money as a special dividend.

Repurchasing stock is a form of residual dividend policy that does not carry the burden of announcing a greater current dividend and being forced to deal with maintaining it across time. In effect, the firm is saying it has funds available that are not needed for current capital expenditures but rather than committing to a long term higher annual dividend, it will repurchase shares sufficient to consume the funds available. This would presumably result in higher earnings per share for remaining shareholders since the repurchased stock would now be held as Treasury stock. The higher EPS could result in a higher stock price which means the remaining shareholders have gained value equal to that which they might have received as a one time special dividend. The firm has assuaged its conscience in the sense that it did not retain funds for which there was no discernible use but there is no justification for expecting it to happen again next year. Partially due to taxation issues and partially due to difficulties inherent in paying a one time special dividend in excess of the normal dividend, share repurchase has gained a strong following in recent years although a healthy level of cynicism may be appropriate.

top

Dividend Reinvestment Plans (DRIPS) have existed for the past quarter century, but have gained popularity in recent years as shareholders seek ways to reduce their cost of equity purchases. In a DRIP, shareholders elect to have their dividends reinvested in new shares automatically by the company or its equity trustee. In an "existing stock" plan, the shares are purchased in the open market, from currently outstanding shares, by the trustee using the funds received as dividends on behalf of the DRIP electing shareholders. The purchase is typically made in a large transaction with relatively low per share costs and the shares are apportioned to DRIP participants on a pro-rata basis relative to the amount of dividends received by each participant. In a "new stock" plan, the company issues new equity shares through the trustee on behalf of the DRIP electing shareholders. This issuance is typically at a price below current market prices and effectively shares the benefit between the DRIP participant and the company of not paying the high flotation costs associated with issuing new stock. It becomes a reduced cost way for the firm to raise new equity funds and provides the shareholder with a means to avoid the risk of either squandering the money on current consumption or paying high brokerage fees to acquire more shares.

DRIP's have gained in popularity during the past 10 years which leads one to consider whether shareholders really want the cash dividend income or would just as soon expand their level of ownership. It may be the way shareholders indicate that while they want the firm to pay them a dividend as proof of being successful, they do not want the money for immediate consumption purposes. There is no tax benefit to a DRIP since the shareholder received taxable income whether it comes in the form of cash or stock via a DRIP so there has to be some other motive at work. In companies offering the DRIP opportunity, approximately one fourth of investors are using it to expand their ownership of the firm so it clearly indicates that the old saw of dividends being attractive to those wanting the money for annual income is at risk.

top

Stock Dividends and Stock Splits are related although treated differently for accounting purposes. A stock split occurs when the firm decides to "split" the existing shares thereby creating a greater number of shares outstanding. For example, a company that has 100,000 shares outstanding decides to do a "3 for 2" split wherein an additional share is issued for each two shares outstanding. Thus, the firm ends up with 150,000 shares outstanding with a proportionate reduction in earnings per share and share price. There is a great deal of anecdotal evidence that purchasing shares immediately prior to a stock split and selling them immediately afterwards will inevitably result in a capital gain. The initial problem is correctly identifying which firm is likely to split the stock and the second problem is that nothing has changed with the assets and associated cash flows of the firm. Any short term price increase is inevitably due to the increased visibility provided by the announcement of the split since it is a relatively unique event in the life of most firms. Given time, the market realizes that nothing has changed at the firm so the value reverts to the pre-split value except that more shares divide that value and each share is worth less than before. If the firm maintains its existing cash dividend per share, the investor gains income although they should question why the management did not simply increase the dividends on the pre-split stock.

Stock splits owe much of their mystique to the possibility of an "ideal price range" that is allegedly somewhere in the $20 to $40 dollar vicinity. The old method of structured commissions by brokerages provided a strong incentive to buy stock in 100 share "round lots" which meant that 100 shares of $70 stock would cost $7,000 which might seem like a large amount to a small investor. Splitting the stock 3 for 1 would bring the price back down to $23.33 per share and a round lot would cost $2,333 which would make it more attainable for a small investor and provide a wider distribution of shareholders. The difficulty today, of course, is that the structured commissions no longer hold and most small investors invest through mutual funds rather than through direct purchases. It is not likely that a mutual fund would have found the $7000 round lot price particularly burdensome.

Stock dividends are similar in that they change the number of share pieces rather than the overall size of the pie. For example, you start with a 10 inch pie divided into 8 equal pieces. There are four people at the table and each can enjoy 2 pieces or 25% of the pie. A pie dividend of 25% is now announced and the same 10 inch pie is cut into 10 pieces. Each person at the table now gets 2.5 pieces of pie or exactly 25% which is what they had before. In other words, nothing changed and you still have the same proportionate ownership as when you started, but you now have additional .5 piece per person although your first two pieces have been reduced in size to the point where you can consume neither more nor less than before. You could always give or sell your new .5 piece to a stranger, but if that was an appealing thought, you could have whacked off a chunk of your initial two pieces and made the exact same offer.

Stock dividends and stock splits do not alter anything in the firm except for the number of pieces of paper that represent ownership. There are some psychological reasons to consider the existence of an attractive price range and there are investors who enjoy speculating on these announcements in hopes of a capital gain. At the core, however, you are just "messing with their mind" in hopes of gaining an undeserved advantage.

top

Useful Web Sites