Determining a Company’s Dividend Payout Policy

Determining a Company’s Dividend Payout Policy explained by professional Forex trading experts the “ForexSQ” FX trading team.

Determining a Company’s Dividend Payout Policy

How Companies Decide When and the Amount of Dividends To Pay Investors

Of the many decisions a company’s board of directors will need to make, one of the most important has to do with the company’s dividend payout policy. If, when, and how much cash a company decides to return to owners in the form of dividends rather than share repurchases, reinvestment, debt reduction, or acquisitions has an enormous influence not only on the total return but on the type of investor who will be attracted to ownership.

I want to take my time this afternoon to give you some insight into the thought processes that might be behind a company’s board when it announces it is following a certain dividend payout policy and a few of the benefits and drawbacks of various dividend philosophies from the perspective of both the business and the stockholder.

In Financial Theory, Ultimately a Company Is Only Worth What It Can Pay In Dividends

If you are at all familiar with basic finance and accounting, you know that, ultimately, the justification for a business having any value at all is overwhelmingly tied to its ability to pay dividends either now or at some point in the future (even if those dividends come in the form of a backdoor return to shareholders, as is the case with stock repurchase plans). It doesn’t matter if you own an enterprise outright, perhaps as a family operated limited liability company, or if you own an enterprise partially through the purchase of individual shares of a corporation in your brokerage account, Roth IRA, direct stock purchase plan, dividend reinvestment plan, index funds, mutual fund, or ETF, at some point, someone down the line, you or a subsequent owner, has to be able to withdraw money from the business in the form of a cash dividend that can be spent, otherwise the business has no economic justification for existing as a use of your capital.

In other words, if there were a policy that the government would tax 100% of any distributions from any business, stocks would have practically no value to outside investors, even companies that didn’t pay dividends because the promise of being able to actually live off the earnings once those companies were mature was now effectively ended.

In many cases, especially those where a company has a good opportunity to plow earnings back into the asset base on the balance sheet to expand at high returns on capital, it may be decades before the first dividend is declared. Sure, some businesses buck this trend – Wal-Mart Stores is an excellent example as it was one of the most successful investments of all time but Sam Walton had his retailing company distribute earnings to stockholders in ever-increasing amounts with each passing year, considering it important to shower some of the prosperity on them along the journey rather than waiting for it all to arrive at the end or requiring people to sell their ownership to cash in on the appreciation that had occurred – but others embody it. Microsoft is one such example.

For almost a generation, Microsoft didn’t pay a dime in dividends as its dividend policy was to retain all earnings to grow the core engine which had huge operating marginsand a breathtaking large return on equity. It hoarded and retained earnings, becoming one of the most successful investments in history the same way Wal-Mart did. If you had invested $100,000 in the IPO on March 13th, 1986, and locked it in a vault until late May 2016, you’d be sitting on something like $53,827,182 in stock and $11,635,807 in cash dividends before taxes, assuming no dividend reinvestment at all (and you know how big a deal dividend reinvestment is so you can only imagine how much more wealth you’d have if you’d been shoveling those dividends back into buying more shares).

Your $100,000 blossomed into $65,462,989 in a mere 30 years, compounding at roughly north of 24% per annum for three consecutive decades in a run that was made for the record books; a run that allowed Bill Gates to build a private holding company called Cascade Investment as well as one of the most effective charitable foundations in the world.

Of that $11,635,807 in approximate dividend income you would have earned, the first dividend wasn’t paid until February 19th, 2003, at which points regular dividends began. Your first dividend would have been around $82,305. Microsoft also declared a one-time massive dividend on November 15th, 2004, as an enormous reward to all of those who had invested. In your case, that one-time payment would have been around $3,168,726; cash that was direct deposited into your brokerage account, checking accounts, or savings account or, alternatively, sent to you as a paper check in the mail.

Over the years, the meteoric rise in stock price was a reflection, albeit imprecise and highly volatile, of investor’s best guess as to the intrinsic value of those future cash streams. If money couldn’t be extracted directly or indirectly out of Microsoft, only a fool would have bought the stock. It was the promise of future payouts, at some point, that drove its return. Again, this is nothing new to any of you who have a background in finance or accounting – basic theoretical stuff – but it’s important to understand before we get into a discussion about dividend payout policy.

Some of the Things a Board May Consider When Determining Dividend Payout Policy

As it makes a determination about which dividend payout policy is appropriate, a company’s board of directors may consider many things including, but not limited to, the following.

What are the opportunities for profitable reinvestment of surplus free cash flow? If you’re a firm that is expanding across the country or world with no end in sight, it doesn’t make sense to pay out a dollar if you can create more than a dollar of value by putting it back to work. If you’re an asset intensive company with low returns on capital, it doesn’t make a lot of sense to keep expanding. Owners would be better off paying out most of the earnings as dividends, effectively liquidating the business to some degree.
How stable and secure is the balance sheet and income statement? Responsible companies need to have adequate cash reserves to absorb periods of economic stress. Some types of businesses have wildly volatile revenue or earnings that require greater management than different, more bucolic financial engines. For these businesses, it can be dangerous to push the dividend payout too high, too quickly. It’s one thing for a diversified utility company to have a 50% dividend payout ratio and another thing entirely for a pure play mining company to have the same. The latter has a significantly higher likelihood of a dividend cut, which can be devastating to passive income investors using a high dividend strategy.
What are the dividend payout policies of other companies in the same sector and industry? It can be difficult to raise capital or attract investors if you have the same economics as your peers yet you offer a much lower dividend yield.
What type of investors does the firm want to attract? Companies that pay regular and growing dividends tend to appeal to wealthier, more stable investors. Additionally, a strong, sustainable dividend can provide an effective floor on a stock, all else being equal, due to something called dividend support; investors rushing into buy it at the point its dividend yield becomes obscenely high, causing it to receive more bidding compared to non-dividend-paying companies when the capital markets are in a free fall. To learn more about this phenomenon, read Why Dividend Paying Stocks Tend to Fall Less During Bear Markets.
What is the particular tax law in place at the time? How are dividends treated?
What are the needs of the major stockholders? You look at a company like Hershey and the fact an enormous portion of the common stock is owned by The Hershey Trust for the benefit of the school and orphanage established by the late Milton Hershey and his wife, and realize that a particular quirk of Pennsylvania law makes it all but impossible for the trust to sell a meaningful amount of stock, and you understand the reason Hershey has to pay a dividend for all intents and purposes. Its major shareholder depends on that income to put thousands of children through school; to pay for food and shelter.

Famed value investor Benjamin Graham wrote about the tendency of directors to come up with irrational dividend payout philosophies that had little bearing on the most intelligent economic course of action, such as paying out 25% of earnings; an arbitrary figure. This appears to happen more than you would expect.

One particularly interesting cultural difference between the United States and the United Kingdom is the general philosophy taken towards dividend payout policy. In the U.K., many businesses tend to distribute dividends in a way Graham would approve, treating payouts on a year-by-year basis and looking at the current earnings and economic forecast the same way a private business might. This creates volatility in the dividend rates of many companies – you may get more or less next year even if the business, over time, does well and increases its dividend on a net basis – whereas this would be completely anathema in the United States. American investors expect and demand companies to smooth dividend increases in a way that dividend cuts are relatively rare so those who rely upon the income can count on it. This means companies don’t push dividend payouts as high as they can during boom years, perhaps building reserves and gently increasing dividends per share at a slower rate to keep up their sterling record of rising payouts. In fact, in this country we celebrate companies that have raised their dividend every year without fail for 25 years or more, calling them “Dividend Aristocrats”. Companies that raised their aggregate dividends at a faster rate but didn’t do so in such a way aren’t included.

One thing that investors should consider in examining a company’s dividend policy is the academic evidence that dividend paying stocks on the whole tend to outperform non-dividend paying stocks. There are a myriad of reasons this is thought to be the case, including:

Dividends can’t be faked. The company either pays the cash out or doesn’t. This results in companies with established dividend payout policies having higher than average “quality of earnings” due to lower accruals between the reported net income on the income statement and the actual cash profits, or owner earnings.
A strong dividend policy serves as a constant reminder to management that the shareholder return must come first. It becomes part of the culture; a way to tangibly measure the good produced for owners.
Established dividend policies have the effect of reducing the total capital available to management for the purposes of mergers and acquisitions. This tends to force executives to be more selective when trying to pursue a deal as money is relatively scarcer.
The dividend yield support phenomenon discussed early allows the company to raise capital more efficiently and at a better price when times are tough due to the perception they are safer as a result of the larger equity capital cushion; the higher market capitalization and enterprise value serving as a source of peace of mind. This means less equity dilution or profit reduction due to a higher cost of capital when the skies grow dark.

More Information on Dividends and Dividend Investing

For more information, read our Complete Guide to Dividends and Dividend Investing.