Dividend policy

Last updated July 25, 2024

Dividend policy, in financial management and corporate finance, is concerned with ^[1]^[2] the policies regarding dividends; more specifically paying a cash dividend in the present, as opposed to, presumably, paying an increased dividend at a later stage. Practical and theoretical considerations will inform this thinking.

Management considerations

In setting dividend policy, management must pay regard to various practical considerations, ^[1]^[2] often independent of the theory, outlined below. In general, 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. At the same time, although the decisioning must weigh the best use of those resources for the firm - i.e. investment needs and future prospects - it must also take into account shareholders' preferences, and the relationship with capital markets more broadly.

As regards the firm: If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then management should return some or all of the excess cash to shareholders as dividends. However, potentially limiting any distribution, the firm's overall finances, liquidity, and legal / debt covenants in place will also be of relevance. Management may also wish to avoid "unsettling" the capital markets ^[1] by changing policy abruptly; see below re signaling.

As regards shareholders: As a general rule, shareholders of "growth companies" would prefer managers to retain earnings so as to fund future growth internally (or have a share buyback program) whereas shareholders of value or secondary stocks would prefer the management to distribute surplus earnings in the form of cash dividends. Re the former, for example, the thinking is dividend payments, and share price, will be higher in the future, (more than) offsetting the retainment of current earnings. See Clientele effect.

Regarding both: Management must 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.

Relevance of dividend policy

Modigliani-Miller theorem

The Modigliani–Miller theorem states that dividend policy does not influence the value of the firm.^[3] The theory, more generally, is framed in the context of capital structure, and states that — in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market — the enterprise value of a firm is unaffected by how that firm is financed: i.e. its value is unaffected by whether the firm is funded by retained earnings, or whether it raises capital by issuing shares or by selling debt.

The dividend decision, relating to both equity financing and retained earnings, is, in turn, value neutral. ^[1] Here, shareholders are indifferent as to how the firm divides its profits between new investments and dividends. The logic, essentially, is that capital used in paying out dividends will be replaced by new capital raised through issuing shares. The latter will increase the number of shares, diluting earnings, and hence lead to a decline in share price. Thus any increase in firm value because of the dividend payment (e.g. per the Gordon model, as below, where value is a function of dividend) will be offset by the decrease in value due to raising new capital.

Gordon model

In contrast to the above, under the dividend discount model, ^[2] and particularly the “Growth model” of Myron J. Gordon, the value of the firm (or at least its equity) is explicitly a function of dividends paid. ^[1] Here investors are seen to prefer a “bird in the hand”: i.e. dividends are certain as compared to income from future capital gains. The resultant valuation formula thus returns value as the present value of “all” future dividends:

P={\frac {D_{1}}{r-g}}

where: $P$ is the current stock price; $g$ is the constant growth rate in perpetuity expected for the dividends; $r$ is the constant cost of equity capital (k_e) for that company; $D_{1}$ is the value of dividends at the end of the first period, which may be substituted with earnings multiplied by a retention ratio.

This formula, essentially, applies a perpetuity formula to the current dividend, set to grow at a sustainable rate. Strictly, it is then to be applied only to “mature “companies. Further, an implication as regards policy, is that (per the formula) dividends are paid only where investors’ required return - i.e. cost of equity, k_e - is greater than the company’s sustainable growth rate. Conversely while the company is enjoying growth in excess of other comparable firms (and k_e) then it should not pay dividends, instead, funding its capital requirement with retained profits.

Lintner's model

John Lintner provides an explicit formula for determining dividend policy; ^[4] it is particularly relevant to a publicly traded company. A key model-assumption is that management will consider two factors in determining the dividend amount, with both indicating higher dividends correspondingly. The first is the net present value of future earnings; the second is the sustainability of these earnings. At the same time, any policy must recognize that investors will prefer to receive their dividend with (some) certainty, and thus, if possible, management will maintain a constant rate of dividend (even if the results in a particular period are not up to the mark). The theory followed the observation ^[4] that companies often set their long-run dividends-to-earnings target as a function of expected NPV positive "projects" (see capital budgeting).

Expressed as a model, two parameters are considered: the target payout ratio and the rate at which 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 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 this model to U.S. stocks, Lintner found $\rho \simeq 30\%$ and $\tau \simeq 50\%$ .

The above implies some symmetry. However, in reality, the progression of dividends is asymmetric: increases in dividend are usually small and frequent, while decreases (including cutting the dividend altogether) are large and infrequent.

Capital structure substitution theory and dividends

The capital structure substitution theory (CSS)^[5] describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on the hypothesis that management "manipulates" capital structure such that earnings per share (EPS) are maximized. As a corollary, the CSS theory is seen to provide management with (some) guidance on dividend policy - more directly in fact than other approaches, such as the Walter model and the Gordon model. In fact, CSS reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa.

The theory provides an explanation as to why some companies pay dividends and others do not: When redistributing cash to shareholders, management can typically choose between dividends and share repurchases. In most cases dividends are taxed higher than capital gains, and thus investors - and management - would typically be expected to select a share repurchase. However, for some companies share repurchases lead to a reduction in EPS, and it in those cases the company would select to pay dividends. From the CSS theory, then, 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

Companies may then "target" a dynamic Debt-to-equity ratio.

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. 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.^[6]

Dividend signaling hypothesis

The dividend signaling hypothesis ^[7]^[8] 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 ^[8] the firm's management will be better informed than the market in estimating the true value of the firm. (See Efficient-market hypothesis.) It has some support in game theory, ^[7] constituting a form of "signaling game".

Note that the concept of dividend signaling has been widely contested. ^[7] At the same time, however, the theory is still used by some investors, ^[7] and is supported by empirical studies ^[8] 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^[9] holds that dividend policy is a function of the relationship between the company's return on investment and its cost of equity; a corollary is that the dividend decision will also affect the value of the company.

The underlying argument^[10] 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, is proxied by its return on equity; while its shareholders' required rate of return is proxied by the firm's cost of equity, or k_e. Thus, if r < k_e then the firm should distribute the profits in the form of dividends; however, if r > k_e then the firm should invest these retained earnings. The value of the company, then, may be seen as the present value of the return on investments made from retained earnings, and a theoretical value is expressed ^[10] as:

$P={D+r((E-D)/k_{e}) \over {k_{e}}}\,$ ^{[ dubious – discuss ]}

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

The model assumes, at least implicitly, that retained earnings are the only source of financing, and that k_e and r are constant; given these assumptions, the approach is subject to ^[10] some criticism.

Residuals theory of dividends

Under a Residual Dividend policy,^[11]^[12] dividends are paid out from "spare cash" or excess earnings; this is to be contrasted with^[11] 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.

Although absent of any explicit link to value, such an approach may, in fact, impact share price: This policy will attract investors who appreciate that the firm is trying to employ its capital optimally (and will require fewer new stock issues with correspondingly lower flotation costs); ^[11] it also delays (or removes) the payment of the secondary tax on dividends; see Retained earnings § Tax implications. ^[12] At the same time, however, such a policy may result in conflicting signals (see above) being sent 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 Residual income valuation.

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.

The Modigliani–Miller theorem is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the enterprise value of a firm is unaffected by how that firm is financed. This is not to be confused with the value of the equity of the firm. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing shares or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

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.

In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt, and preferred stock, and is detailed in the company's balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible.

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.

<span class="mw-page-title-main">Capital budgeting</span> How an organization allocates its cash and resources

Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structures. It is the process of allocating resources for major capital, or investment, expenditures. An underlying goal, consistent with the overall approach in corporate finance, is to increase the value of the firm to the shareholders.

Valuation using discounted cash flows is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach".

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 assertion that intrinsic value is determined by the sum of future cash flows from dividend payments, discounted back to their present value. 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 publicly listed, 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.

Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of businesses, 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

1 2 3 4 5 Ken Garrett (ND). Dividend theory. Association of Chartered Certified Accountants
1 2 3 Aswath Damodaran (N.D.). Returning Cash to the Owners: Dividend Policy
↑ James Chen (2023). Dividend Irrelevance Theory: Definition and Investing Strategies. investopedia.com
1 2 Adam Hayes (2023). "Lintner's Model: Meaning, Overview, Formula", investopedia.com
↑ 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 3 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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[ACCA-1] 1 2 3 4 5 Ken Garrett (ND). Dividend theory. Association of Chartered Certified Accountants

[Damodaran-2] 1 2 3 Aswath Damodaran (N.D.). Returning Cash to the Owners: Dividend Policy

[3] James Chen (2023). Dividend Irrelevance Theory: Definition and Investing Strategies. investopedia.com

[Hayes_L-4] 1 2 Adam Hayes (2023). "Lintner's Model: Meaning, Overview, Formula", investopedia.com

[5] 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)

[6] 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-7] 1 2 3 4 Adam Hayes (2022). "Dividend Signaling: Definition, Theory, Research, and Examples", Investopedia

[Bossaerts_and_0degaard-8] 1 2 3 § 20.6 in Peter Bossaerts and Bernt Arne 0degaard (2006). Lectures on Corporate Finance (Second Edition). World Scientific Publishing. ISBN 9789812568991

[9] 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-10] 1 2 3 Sanjay Borad (2022). "Walters theory on dividend policy"

[Thakur-11] 1 2 3 Rani Thakur (2024). "Residual Dividend Model"

[CFI-12] 1 2 CFI Education Inc (2015). "Residual Dividend Policy"

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