Dividend policy

Last updated May 31, 2024

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess earnings so as to fund future growth internally. By with holding current dividend payments to shareholders, managers of growth companies are hoping that dividend payments will be increased proportionality higher in the future, to offset the retainment of current earnings and the internal financing of present investment projects.

Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders. As a general rule, shareholders of growth companies would prefer managers to have a share buyback program, whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends.

Relevance of dividend policy

Lintner's model

John Lintner's dividend policy model is a model theorizing how a publicly traded company sets its dividend policy. The logic is that every company wants to maintain a constant rate of dividend even if the results in a particular period are not up to the mark. The assumption is that investors will prefer to receive a certain dividend payout.

The model states that dividends are paid according to two factors. The first is the net present value of earnings, with higher values indicating higher dividends. The second is the sustainability of earnings; that is, a company may increase its earnings without increasing its dividend payouts until managers are convinced that it will continue to maintain such earnings. The theory was adopted based on observations that many companies will set their long-run target dividends-to-earnings ratios based upon the amount of positive net-present-value projects that they have available.

The model then uses two parameters, the target payout ratio and the speed where current dividends adjust to that target:

 ${\begin{aligned}D_{t}&=D_{t-1}+\rho \cdot \left(D_{t}^{*}-D_{t-1}\right)\\&=D_{t-1}+\rho \cdot \left(\tau \cdot E_{t}-D_{t-1}\right)\\&=\rho \cdot \tau \cdot E_{t}+(1-\rho )\cdot D_{t-1}\\&=\rho \cdot D_{t}^{*}+(1-\rho )\cdot D_{t-1}\end{aligned}}$

where:

$D_{t}$ is the dividend per share at time $t$
$D_{t-1}$ is the dividend per share at time $(t-1)$ , i.e. last year's dividend per share
$\rho$ is the speed of adjustment rate or the partial adjustment coefficient, with $0\leq \rho \leq 1$
$D_{t}^{*}$ is the target dividend per share at time $t$ , with $D_{t}^{*}=\tau \cdot E_{t}$
$\tau$ is the target payout ratio on earnings per share (or on free-cash-flow per share), with $0\leq \tau \leq 1$
$E_{t}$ is the earnings per share (or free-cash-flow per share) at time $t$

When applying its model to U.S. stocks, Lintner found $\rho \simeq 30\%$ and $\tau \simeq 50\%$ .

Capital structure substitution theory and dividends

The capital structure substitution theory (CSS)^[1] describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share (EPS) are maximized. The resulting dynamic debt-equity target explains why some companies use dividends and others do not. When redistributing cash to shareholders, company managements can typically choose between dividends and share repurchases. But as dividends are in most cases taxed higher than capital gains, investors are expected to prefer capital gains. However, the CSS theory shows that for some companies share repurchases lead to a reduction in EPS. These companies typically prefer dividends over share repurchases.

From the CSS theory it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than

{\frac {D}{E_{\text{q}}}}>{\frac {1-T_{\text{C}}}{1-T_{\text{D}}}}-1

should prefer dividends as a means to distribute cash to shareholders, where

D is the company's total long-term debt
$E_{\text{q}}$ is the company's total equity
$T_{\text{C}}$ is the tax rate on capital gains
$T_{\text{D}}$ is the tax rate on dividends

Low-valued, high-leverage companies with limited investment opportunities and a high profitability use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.^[2]

The CSS theory is thus seen to provide more guidance on dividend policy to company management than the Walter model and the Gordon model. It also reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa. The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way.

Dividend signaling hypothesis

The dividend signaling hypothesis ^[3]^[4] posits that a company's announcement of an increase in dividend payouts constitutes an opportunity to signal to the market that the firm is "better off than the average". Increasing a company's dividend payout may then predict (or lead to) favorable performance of the company's stock in the future. (See also Earnings guidance.)

The theory is built on the assumption that, although in a perfect market there is no information asymmetry, in practice ^[4] the firm's management will be better informed than the market in estimating the true value of the firm. (See Efficient-market hypothesis and Modigliani–Miller theorem.) It has some support in game theory, ^[3] constituting a form of "signaling game".

Note that the concept of dividend signaling has been widely contested. ^[3] At the same time, however, the theory is still used by some investors, ^[3] and is supported by empirical studies ^[4] showing that a firm's share price may increase significantly upon announcement of dividend increases, despite the cost inherent in the dividend tax.

Walter's model

Walter's model ^[5] holds that dividend policy is a function of the relationship between the company's return on investment and its cost of equity, and hence also affects the value of the company. The argument ^[6] is that capital retained will be invested by the firm in its profitable opportunities, whereas dividends paid to shareholders are invested elsewhere. Here, the firm's achievable rate of return, r, reflects as its return on equity; while the shareholders' required rate of return, is proxied by the firm's cost of equity, or ke. Thus, if r < ke then the firm should distribute the profits in the form of dividends; however, if r > ke then the firm should invest these retained earnings. The model assumes, at least implicitly, that retained earnings are the only source of financing, and that ke and r are constant (given these, the approach is subject to criticism). Firm value, then, may be seen as the present value of the return on investments made from retained earnings, and a theoretical value is then expressed ^[6] via:

$P={D+r((E-D)/k_{e}) \over {k_{e}}}\,$

where,

P = Market price of the share
D = Dividend per share
r = Rate of return on the firm's investments
k_e = Cost of equity
E = Earnings per share

Residuals theory of dividends

Under a Residual Dividend policy, ^[7]^[8] dividends are paid out from "spare cash" or excess earnings - this is to be contrasted with ^[7] a "smoothed" payout policy. A firm applying a residual dividend policy will evaluate its available investment opportunities to determine required capital expenditure, and in parallel, the amount of equity finance that would be needed for these investments; it will also confirm that the cost of retained earnings is less than the cost of equity capital. If appropriate, it will then use its retained profits to finance capital investments. Finally, if there is any surplus after this financing, then the firm will distribute these residual funds as dividends.

This policy will attract investors who appreciate that the firm is employing its capital optimally;^[7] it also delays (or removes) the payment of the secondary tax on dividends. This policy, furthermore, requires fewer new stock issues and hence lower flotation costs.^[8] At the same time, a variable dividend policy may send conflicting signals to investors. It also represents an increased level of risk for investors, as dividend income remains uncertain, and the share price may respond correspondingly. See also Residual income valuation and Retained earnings § Tax implications.

External links

Dividend Policy by Alex Tajirian
Corporate Dividend Policy by Henry Servaes (London Business School) and Peter Tufano (Harvard Business School)

Related Research Articles

<span class="mw-page-title-main">Dividend</span> Payment made by a corporation to its shareholders, usually as a distribution of profits

A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business. The current year profit as well as the retained earnings of previous years are available for distribution; a corporation is usually prohibited from paying a dividend out of its capital. Distribution to shareholders may be in cash or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or by share repurchase. In some cases, the distribution may be of assets.

<span class="mw-page-title-main">Equity (finance)</span> Ownership of property reduced by its liabilities

In finance, equity is an ownership interest in property that may be offset by debts or other liabilities. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets owned. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market.

Stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.

In economics and accounting, the cost of capital is the cost of a company's funds, or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

In financial accounting, free cash flow (FCF) or free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets. It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations. As such, it is an indicator of a company's financial flexibility and is of interest to holders of the company's equity, debt, preferred stock and convertible securities, as well as potential lenders and investors.

The retained earnings of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that period, the net income at that point is transferred from the Profit and Loss Account to the retained earnings account. If the balance of the retained earnings account is negative it may be called accumulated losses, retained losses or accumulated deficit, or similar terminology.

John Virgil Lintner, Jr. was a professor at the Harvard Business School in the 1960s and one of the co-creators of the capital asset pricing model.

Share repurchase, also known as share buyback or stock buyback, is the reacquisition by a company of its own shares. It represents an alternate and more flexible way of returning money to shareholders. When used in coordination with increased corporate leverage, buybacks can increase share prices.

Earnings growth is the annual compound annual growth rate (CAGR) of earnings from investments.

In financial economics, the dividend discount model (DDM) is a method of valuing the price of a company's capital stock or business value based on the fact that their corresponding value is worth the sum of all of its future dividend payments, discounted back to their present value. In other words, DDM is used to value stocks based on the net present value of the future dividends. The constant-growth form of the DDM is sometimes referred to as the Gordon growth model (GGM), after Myron J. Gordon of the Massachusetts Institute of Technology, the University of Rochester, and the University of Toronto, who published it along with Eli Shapiro in 1956 and made reference to it in 1959. Their work borrowed heavily from the theoretical and mathematical ideas found in John Burr Williams 1938 book "The Theory of Investment Value," which put forth the dividend discount model 18 years before Gordon and Shapiro.

In finance, the T-model is a formula that states the returns earned by holders of a company's stock in terms of accounting variables obtainable from its financial statements. The T-model connects fundamentals with investment return, allowing an analyst to make projections of financial performance and turn those projections into a required return that can be used in investment selection.

According to PIMS, an important lever of business success is growth. Among 37 variables, growth is mentioned as one of the most important variables for success: market share, market growth, marketing expense to sales ratio or a strong market position.

<span class="mw-page-title-main">Financial ratio</span> Numerical value to determine the financial condition of a company

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in book value. The theory's primary use is to estimate the value of a company's shares. The secondary use is to estimate the cost of capital, as an alternative to e.g. the CAPM. The "clean surplus" is calculated by not including transactions with shareholders when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends.

Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

Residual income valuation is an approach to equity valuation that formally accounts for the cost of equity capital. Here, "residual" means in excess of any opportunity costs measured relative to the book value of shareholders' equity; residual income (RI) is then the income generated by a firm after accounting for the true cost of capital. The approach is largely analogous to the EVA/MVA based approach, with similar logic and advantages. Residual Income valuation has its origins in Edwards & Bell (1961), Peasnell (1982), and Ohlson (1995).

The sum of perpetuities method (SPM) is a way of valuing a business assuming that investors discount the future earnings of a firm regardless of whether earnings are paid as dividends or retained. SPM is an alternative to the Gordon growth model (GGM) and can be applied to business or stock valuation if the business is assumed to have constant earnings and/or dividend growth. The variables are:

References

↑ Timmer, Jan (2011). "Understanding the Fed Model, Capital Structure, and then Some". doi:10.2139/ssrn.1322703. S2CID 153802629. SSRN 1322703.{{cite journal}}: Cite journal requires |journal= (help)
↑ Fama, E.F.; French, K.R. (April 2001). "Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay". Journal of Financial Economics. 60: 3–43. doi:10.1016/s0304-405x(01)00038-1. SSRN 203092.
1 2 3 4 Adam Hayes (2022). "Dividend Signaling: Definition, Theory, Research, and Examples", Investopedia
1 2 3 § 20.6 in Peter Bossaerts and Bernt Arne 0degaard (2006). Lectures on Corporate Finance (Second Edition). World Scientific Publishing. ISBN 9789812568991
↑ James E. Walter (1963). "Dividend Policy: Its Influence on the Value of the Enterprise". The Journal of Finance . Vol. 18, No. 2 (May, 1963), pp. 280-291.
1 2 Sanjay Borad (2022). "Walters theory on dividend policy"
1 2 3 Rani Thakur (2024). "Residual Dividend Model"
1 2 CFI Education Inc (2015). "Residual Dividend Policy"

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[1] Timmer, Jan (2011). "Understanding the Fed Model, Capital Structure, and then Some". doi:10.2139/ssrn.1322703. S2CID 153802629. SSRN 1322703.{{cite journal}}: Cite journal requires |journal= (help)

[2] Fama, E.F.; French, K.R. (April 2001). "Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay". Journal of Financial Economics. 60: 3–43. doi:10.1016/s0304-405x(01)00038-1. SSRN 203092.

[Hayes-3] 1 2 3 4 Adam Hayes (2022). "Dividend Signaling: Definition, Theory, Research, and Examples", Investopedia

[Bossaerts_and_0degaard-4] 1 2 3 § 20.6 in Peter Bossaerts and Bernt Arne 0degaard (2006). Lectures on Corporate Finance (Second Edition). World Scientific Publishing. ISBN 9789812568991

[5] James E. Walter (1963). "Dividend Policy: Its Influence on the Value of the Enterprise". The Journal of Finance . Vol. 18, No. 2 (May, 1963), pp. 280-291.

[Borad-6] 1 2 Sanjay Borad (2022). "Walters theory on dividend policy"

[Thakur-7] 1 2 3 Rani Thakur (2024). "Residual Dividend Model"

[CFI-8] 1 2 CFI Education Inc (2015). "Residual Dividend Policy"

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