© 2000 John Petroff
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© 2000 John Petroff |
The dividends that are distributed from the current year earnings have a direct impact on the capital structure, the future growth of the firm, and the value of the company to outside investors and owners. From the available theoretical research and from writings of professional practitioners, there does not seem to be one optimal dividend distribution strategy (which would be similar to the optimal capital structure theory seen in the previous chapter). Instead, there are two or three guiding rules relating to dividend distribution which are presented below. However, some dividend policies may be detrimental to a firm, and for those, a financial analyst ought to be on the alert.
a)- Interpretation of dividend data:
Dividends can be of different types. Ordinary dividends are cash payments which must come from current or prior year earnings (i.e. not from capital or paid-in capital because it is prohibited in most countries), which are decided by the board of directors, which are paid (usually quarterly) to holders of common shares, and which come as a reduction of the earnings to be retained. Special or extraordinary dividends are also cash payments which are added to ordinary dividends in the years when earnings are unusually large. There are also preferred shares dividends which are cash payments, but only for the holders of preferred shares: they are most often fixed (although a few are "participating" in earnings), and cumulative (i.e. if one year payment is missed it accrues for next year).
Common shareholders also may occasionally receive stock dividends which consist of the distribution of one new share of the corporation for a given number of existing outstanding shares. If the proportion is more than one new share for four existing shares, the distribution is said to be a stock split rather than a stock dividend. From an accounting point of view, a stock dividend requires assigning a portion of retained earnings to capital (and possibly paid-in capital), whereas a stock split does not change capital, only the number and unit value of the shares outstanding. Instead of a stock dividend, shareholders may receive pre-emptive rights to acquire new shares at a reduced price. These rights have a value equal to the difference between the market price and the subscription price. A right provides additional cash for the shareholder if sold, or the ability to preserve the fractional ownership in the corporation. Occasionally, there may be a dividend distributed in kind to shareholders, that is, a physical asset given to each shareholder, but this is only found in closely-held corporations. Finally, there are also liquidating dividends in cash or in kind, which are distributed when a firm is closing down.
What constitutes a dividend policy is primarily determined by the proportion of ordinary cash dividends paid from current year earnings. This proportion is known as the payout ratio. The portion that goes to retained earnings is known as the retention rate.
b)- Steady dividend or payout ratio:
One will recall from Chapters 2 and 3, that maintaining an image of stability is important to a company in order to keep the perceived risk premium low. The discounted dividend model of share value explicitly makes dividends the essential determinant of stock prices. Instability in dividends would create instability in stock price, cause a higher BETA (i.e. a higher risk premium), and result, consequently, in a lower stock price. This all-important stability of dividends can be accomplished by distributing the same ordinary dividend year after year. In exceptionally good years, some extraordinary dividends may be paid out. The dividends are designated as extraordinary to inform shareholders that these added dividends are not to be expected every year in the future. However, the ordinary dividends should grow in step with earnings. Thus, the board of directors sets the dividend at some target proportion of long run average earnings.
Stock dividends and stock splits do not, in theory, add any wealth to shareholders: each shareholder keeps exactly the same fraction of a combined net worth that does not change as a result of the stock distribution. The only effect is that there are more shares, with each having a lesser value. In practice however, there are benefits to existing shareholders. First, the reason for a stock split is to make it easier to sell shares that have risen in price to over one hundred dollars which would make it harder for buyer and sellers of the stock. Remember that share lots are normally 100, and buying 100 shares at $500 each, is a $50,000 transaction; this is a large transaction which limits the appeal of this stock to investors holding well diversified portfolios. In today's electronic trading world, round lots do not have the same importance as in the past. Yet, stock prices of several hundred dollars are still looked upon as impediment to trade. Prices in the range of $30 to $80 are most common.
Second, a stock split conveys a message to investors that the company has grown. The combined market price of the new shares is often higher than earlier quotations of the corresponding number of shares before the stock split. Stock dividends may have a similar message, but not always. Instead, they give the shareholder the opportunity to sell some shares and derive current income without having to disturb shareholder's investment portfolio. On occasion, the stock dividend is used in lieu of an extraordinary cash dividend. In other cases, however, the stock dividend is distributed in lieu of ordinary dividend, which is not a healthy sign because it suggests that current year earnings are not sufficient to distribute an ordinary dividend.
In countries where capital gains receive a beneficial tax treatment (which was the case of the United States until 1986), stock dividends and stock splits may be more appealing to shareholders than cash dividends. Capital gains are calculated as the excess of the selling price over the purchase price if the share has been held usually for more than 6 or 12 months depending on tax provisions of the country. The tax is often half of the ordinary income tax rate. Thus a considerable benefit is derived by shareholders.
c)- Irrelevance of dividend policy:
Numerous studies have shown that it does not make any difference
to the wealth of shareholders whether
1- a company pays a large proportion of its earnings, or
2- a company pays little or no dividends, but achieves a higher
growth rate by reinvesting the earnings it does not distribute.
In fact, companies that need to grow fast would need to access
the capital market to issue new shares more often if they did
distribute dividends. Issuing shares can be costly, as will discussed
in next section. It does not make sense to distribute dividends
and issue new shares at the same time, unless flotation costs
are manageable such as in dividend reinvestment plans. For instance,
AT&T sends a dividend reinvestment offer together with their
mailing of cash dividend payments. This strategy satisfies both
corporate and individual shareholder's needs.
The dividend policy, while affecting the financing strategy of the firm, is more justified by investors' attitudes than corporate needs. Investors who rely on cash dividends for living will put a premium on stocks that have a steady dividend policy. Such investors will prefer these shares, and will expect from the board of directors that it will continue its policy of regular dividends. The companies that fall in this category, are those which have reached the standardization phase in their product life cycle, such as for instance, utilities. Their market and earnings are steady. The need for new growth is moderate.
At the other extreme are investors who seek capital gains from growth stocks. For this group of investors, dividends are not only undesirable because they cut into company growth, but they can also be inconvenient because of the tax liability they create for recipients. Companies in this category come from new consumer product or advanced technology sectors. In the early 1990's, biogenetics may be an example of a field with high potential growth, in late 1990's internet companies. All through the 1980's, Apple Computers did not distribute any dividend.
In between, lies a large group of investors that want stocks with growth potential (preferably from internal financing), but also a reassurance of steady dividends (which signal healthy earnings). The majority of corporations in the United States and many other countries fall in this category. The average payout ratio in the United States has been around 50% over the past half century.
e)- Assessing dividend policies:
This 50% payout rate is an average, many firms distribute more. If a firm is a growth one, a large distribution will jeopardize its growth potential, and the payout rate should be much less than 50%. The financial analyst should also be weary of firms with excessively conservative attitudes: if a company has very moderate growth in sales of standardized products, but sufficient and secure profits, no dividend distribution does not make sense. The conclusion is that the dividend policy appropriate for a firm must be in line with its marketing and investment strategies on the one hand, and the needs and expectations of shareholders, on the other.
The 50% payout rate in the United States is higher than in most countries. In European countries, the payout rate is lower. There are legal and institutional reasons for this. As mentioned earlier, many countries require that a portion of earnings be set aside, sometimes 5%, 10% or even higher, (these are the previously discussed legal and statutory reserves). Difficult access to capital markets or poorly organized capital markets are additional reasons for companies outside the United States to pay less dividends. For all these reason, internal reinvestment of earnings is prevalent. But, as emerging capital markets become more active and efficient, this is likely to change in the future.
| In Russia, internal reinvestment of earnings would seem to be warranted because of the growth needs of all firms, the precarious state of emerging stock markets and high taxes. But there seems to be a clientele effect: shareholders who feel insecure and want a rapid return on their investment. Thus, some Russian firms pay out large dividends, or promise to do so. |
See review questions Q-12A2.1 through Q-12A2.23.
See research assignments R-12A2.1 through R-12A2.3.
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