Firms Should Avoid Swings in Dividend Payout
Capital Allocation and Dividend Policy: Companies Should Avoid Sharp Swings In Dividends
By Joel Stern (adapted by SVM)
SUMMARY: Too often boards of directors establish or alter dividend policies for the wrong reasons. They attempt to communicate management's expectations about profitability by changing the dividend payout substantially, or, worse, they subordinate the firm's dividend policy to their investment decision-making. Our decision rule is that dividend policy should be stable in relation to normalized earnings because the clientele of shareholders wants the greatest, consistent after-tax rate of return on their investment.
Too often boards of directors establish or alter dividend policies for the wrong reasons. They attempt to communicate management's expectations about profitability by changing the dividend payout substantially, or, worse, they subordinate the firm's dividend policy to their investment decision-making. In both cases, the unfortunate and unintended by-products often are a considerable decline in their shareholders' wealth and a greater volatility of share price movements.
These results, however, are unnecessary. Formulating a proper role for the firm's dividend policy could enhance the shareholders' wealth and generate more confidence in the company's management. A recent example is representative and illustrates the problem. (All data have been disguised).
DIVIDEND AS A COMMUNICATION DEVICE
Not long ago, a manufacturer asked us to evaluate a proposal to increase the cash dividend paid to its common shareholders. In the previous decade, the company had paid 50 cents a share annually. Shortly thereafter, its profitability deteriorated and, hence, the board of directors voted to reduce the dividends to 20 cents, about 50 per cent of management's estimate of "normalized" profits (i.e., profits adjusted for unusual and non-recurring events).
But now that the company's performance had improved substantially - profits were up 180 per cent over the past five years to $1.30 a share in the most recent year - the chief financial officer (CFO) suggested that the cash dividends be increased to 50 cents. His objective was to demonstrate the permanence or recurring nature of the company's profitability. If the company's dividend payments were raised substantially, the CFO believed the market would interpret the change in policy as management's conviction that recent profit levels were here to stay. The view was that management would hardly increase the dividend payment to a level it could not expect to service.
This appeared to be a reasonable presumption. However, we were told that the company anticipated substantial needs for capital on which it expected to earn a much greater rate of return than its shareholders could hope to earn by investing in other securities of similar risk. The natural question to ask was: why pay out profits with one hand that the company will have to ask the shareholders to return to the other hand, especially, if management expects to do better with funds retained in the business?
THE BEST DIVIDEND POLICY
If in the real world there were no income taxes and no costs of buying or selling securities (the latter is now in large part almost a reality thanks mainly to Robin Hood Financial), the proper dividend policy would be to pay out nothing to the shareholders, if management expected to earn more on new investments than the shareholders would expect by investing elsewhere in securities of similar risk. In this hypothetical world, investors could sell shares occasionally to obtain cash for their immediate subsistence or to invest elsewhere in real estate, savings accounts, etc.
In the real world of both taxes and transactions costs, a large number of investors prefer cash dividends because they pay little or no taxes on ordinary income. Included in this group are many retired people and large pension funds. For others in high income tax brackets, little or no cash dividends are preferable because the costs of capital gains taxes and selling securities are far less than the tax on ordinary income. Hence, an interesting phenomenon occurs when a company sells shares to the public for the first time. A clientele effect builds up as investors with particular needs are attracted to the company for, among other reasons, the tax consequences of the dividend policy.
Therefore, if management's objective is to act in the best interests of its company's shareholders, it should never alter the fraction of normalized earnings to be paid out as cash dividends. The dividend payout ratio (i.e., dividends paid as a per cent of earnings) should be maintained in order that the return expected by the shareholders from dividends remains a fixed per cent of the total return they expect on the average over a period of time from dividends plus capital appreciation. This will occur as long as the average price/earnings ratio does not change significantly over time.
This policy should be maintained during exceptional and poor years. If a substantial decline in profits was reported in 2019 but management foresaw bright prospects for 2020, any decline in the dividend payment in 2019 should have been based on their judgment of the permanent nature of the earnings drop. Likewise, an increase in profits that resulted from a decline in interest rates (e.g., the business of a bond dealer) should have been considered non-recurring, unless management expected interest rates to continue falling.
Returning to the case of the manufacturer, the board of directors had a conscious policy of paying out about 50 cents of dividends for each dollar of normalized earnings. When the company's earnings declined in the precious decade, the policy should have been maintained. However. the board of directors of the company reduced the fraction of earnings paid out as dividends during the early part of this decade, principally because the earnings grew rapidly, and the dividend payments remained 20 cents a share annually.
Ten years is far too long for the shareholders to delay altering their investment portfolios in order to obtain their accustomed, expected and desired payout. The shareholders would have increased their investment in other higher dividend-paying shares in order to realize their desired level of current ordinary income. Thus, the best policy for the manufacturer today would be to increase the dividend payment at the same rate as the rate of growth in normalized earnings, maintaining the lower payout ratio of the last few years, because the shareholders today would want this policy. It would afford them the greatest after-tax return on their investment.
SUBORDINATING DIVIDENDS TO INVESTMENT POLICY
Many companies that have large capital needs exceeding their internally-generated cash flow reduce their dividend payout ratios because their managements expect greater rates of return on new investments than the shareholders could expect to earn by investing in other securities of similar risk. The management's rationale is that such a policy is in their shareholders' best interest. It is true that investment opportunities that are expected to outperform the shareholders' options should increase the price of the company's common shares. But dividend policy need not (and should not!) be altered in order to accommodate the investment strategy.
Aside from the cost and tax trade-offs mentioned earlier, retaining earnings (rather than paying out dividends) is equivalent to paying dividends and issuing new shares of common equity to replace the dividend payment. If superior investment opportunities are available to the firm, the shareholders want them to be undertaken by issuing new common shares (if necessary) rather than cutting back on cash dividends.
Once again, our decision rule is that dividend policy should be stable in relation to normalized earnings because the clientele of shareholders wants the greatest, consistent after-tax rate of return on their investment.