Friday, February 18, 2011

Dividend Policy for the 21st century

This is the fourth of a series of posts that I have on dividend policy, starting with the one noting the shift from dividends to stock buybacks, moving on to examining whether buybacks are good news for stockholders and then looking at the consequences for investment strategies of the shift. In this post, I would like to examine how companies should think about dividends in a globalized economy, with relatively few safe havens.

The best way to describe dividend policy at most US and European companies is that dividends are sticky. Put differently, the dividend per share this year at most companies will be set at either last year's level or will be a little bit more. Cutting dividends is viewed as an action of last resort, when all else has been tried and failed. If you combine the reluctance to cut dividends with their stickiness, it is no wonder that dividend changes lag earnings changes. In fact, a  study, by John Lintner in 1956, of how US companies set dividends came to almost exactly the same conclusions, showing how little dividend policy has changed over the decades. This policy, in turn, can be traced back to the origins of stock markets: stocks were sold to investors as bonds with price appreciation, and the larger and more stable the dividends, the better the stock was considered to be. Growth was viewed as icing on the cake.

But does this policy make sense? After all, what differentiates debt from equity is that debt generates fixed (and contractual) claims on the cash flows, whereas equity gets whatever is left over (a residual claim). Companies that lock themselves into fixed dividends are in effect turning their equity into quasi bonds and taking away the primary benefit of using equity: its flexibility. Playing devil's advocate, though, there are two reasons given in defense of this established policy. The first is that it commits managers to returning cash to stockholders, who can then decide where to invest that cash. To the extent that you (as a stockholder) don't trust managers in companies to invest your cash, this is a good thing. The second is that dividends can be used as a signal by companies: firms with good growth prospects can increase dividends to indicate their confidence in future prospects. There are real costs to this policy, though. The first is that companies, fearing the consequences of cutting dividends, will be conservative about paying dividends, tending to set them well below cash flows. The second is that companies that get locked into unsustainable dividends will continue to do so and end up in much worse trouble.

As globalization and competition increase uncertainty about future earnings, sticking with "fixed dividends" will result in firms paying less  in dividends (and the trend lines bear this out) and retaining more cash to cover future shortfalls. So, what are the options? Two variations are already in play:
a. Dividends + Stock Buybacks: This is the policy that US companies have adopted for much of the last two decades. While buybacks provide more flexibility to companies, the downside is that they may give them too much flexibility to managers. Thus, managers who prefer to sit on large cash balances will continue to do so.
b. Regular Dividends + Special Dividends: In countries where stock buybacks are either uncommon or restricted, companies supplement regular dividends (which are sticky) with special dividends in periods of high cash flows.
In effect, these two choices preserve the "fixed dividend " policy and supplement it with additional cash returns.

There are more revolutionary alternatives that firms should consider:
a. Fixed payout ratio: In much of Latin America, firms have sticky payout ratios (rather than sticky dividends). Thus, a firm will pay out 35% of its net income as dividends each period, resulting in dividends that vary with earnings. On the plus side, this allows firms to suspend dividends during periods of negative earnings, with little fanfare and signaling consequence. On the minus side, the problem with linking dividends to net income is that the earnings are not cash flows; a firm can have positive net income and negative cash flows, especially if it has significant reinvestment needs.
b. Residual cash flow payout: A simple modification of the fixed payout ratio would be to tie dividends to residual cash flows, computed after reinvestment needs have been met.
Residual Cash flow (FCFE) = Net Income + Depreciation - Capital Expenditures - Change in non-cash working capital
In fact, you can bring in net debt repayments that have to be made into this computation as well. In valuation terms, the dividend would then be set at a fixed percentage of the free cash flow to equity, with the percentage varying across companies. Thus, a company with stable and predictable cash flows may set dividends at 90% of free cash flow to equity, whereas one with uncertain cash flows and reinvestment needs may set it at 65% of free cash flow to equity. This approach preserves the commitment feature of conventional dividends without the inflexibility.
c. Contingent Dividends: The earnings (and cash flows) at some companies are more a function of movements in a macro variable (say oil prices or interest rates) than firm-specific actions. Thus, an oil company will see its cash flows surge if oil prices hit $100 a barrel and drop off if they hit $ 40 a barrel. Rather than force this company to set a fixed dividend, which it may worry about sustaining if oil prices drop, dividends paid can be partially or fully tied to movements in oil prices. This allows the firm to pre-commit to returning cash flows to stockholders (as is the case with conventional dividends) without putting their financial health in jeopardy.

To illustrate how these different policies would affect the dividends that investors receive, I have used Proctor & Gamble and the time period from 2001 to 2010:

Between 2001 and 2010, P&G paid out 41.65% of their net income in dividends. If you add in stock buybacks, they returned 110% of their earnings to stockholders and 120% of their cash flow to equity; they borrowed more money to fund their business. While the prudence of increasing leverage can be debated, that is not the purpose of this post. Instead, the chart notes the volatility in cash flows to stockholders created by the stock buyback policy (note in particular the jump in 2006). P&G could have returned the same aggregate cash flows to equity investors by paying a fixed payout ratio (110% of net income each year) or by returning 120% of their FCFE each year.

Investors who are used to receiving a fixed dividend check in the mail will undoubtedly be disappointed. However, if your primary motivation in buying stock is earning a fixed dividend, would you not be better off buying a bond instead? Ironically, forcing companies to pay a fixed dollar dividend can result in fewer companies paying dividends and those that do paying less in dividends. Perhaps, it is time for a reset on dividend policy.


MDZ said...

I've always had trouble with the idea that a stock buyback was returning capital to shareholders. This is a basic logical problem -- a dividend returns capital to all shareholders, a buyback returns capital to someone who may not be a shareholder anymore. The buyback is actually capital invested in the business -- specifically invested in reducing the number of shareholders. The important question seems to be why companies invest so much money to reduce the number of shareholders and appear to have a preference to doubling down in this way, rather than returning capital to shareholders?

Aswath Damodaran said...

A buyback is cash returned to stockholders. It just gives you a choice, as a stockholder, as to whether you want to cash out (some or all of your holding) or stay in. Unlike dividends, where everyone is forced to take the cash and pay taxes, that flexibility strikes me as a good thing.

Mike said...

Hi Prof,
Nice article, thank you for sharing your thoughts. I have a couple of comments, questions:

However, if your primary motivation in buying stock is earning a fixed dividend, would you not be better off buying a bond instead?
Perhaps, a stronger motivation is the fact that historically stocks bring more return compared to what bonds yield.

Ironically, forcing companies to pay a fixed dollar dividend can result in fewer companies paying dividends and those that do paying less in dividends. Perhaps, it is time for a reset on dividend policy.
Who is forcing the companies to pay a fixed divident? Is it the shareholders, directors or the peer pressure, market forces? Could you please elaborate?

Subu said...

MDZ - Say you and I start a lemonade stand with equal number of shares, say one each worth $50.

Dividends: This year, our business makes $50 in profits, and we get $25 each.

Stock buyback: The business makes $50 in profits and the business buys out your share for the FMV of $50 and reties it. Now I am the sole owner.

Do you agree that the share buyback by the business transferred wealth to the remaining shareholders (me)?

Aswath Damodaran said...

In what way? The other co-owner cashed out half of the business and took the cash (to invest elsewhere or spend). You are the sole owner of a small business. Which one of you comes of this the winner? Who knows?

Unknown said...

Respected sir
It is quite some time since i read you. Am from india, and i would like you to bring a article comparing vis-a-vis investment in stock markets,commodity markets,currency markets and in bank's deposits.

It will be of very useful to novice people like me if u can post it with examples. Much anticipated.



"Why neither a reply nor a comment? I dont think that i have asked you anything bad?"

Aswath Damodaran said...

I wish I had something profound to say but my analysis of where to invest is simple. Look at the risk/return tradeoff and go where you get the most bang for your buck. In the next week, I will be posting my latest equity risk premium update and it is really a paper on quantifying this trade off.

Subu said...

Ashwath, I was merely responding to "a buyback returns capital to someone who may not be a shareholder anymore" - that's not right, the buyback returns capital to existing shareholders as well by increasing their ownership of the business.

All other things being identical, I'd rather own an entire business than half of it.

As for who comes out ahead, that depends on whether the shares are over- / under- valued at the time of the buyback!

Aswath Damodaran said...

You may own the entire business, but it is half the size of the old business.

HelicalZz said...

Prof. Damodaran,

Since you titled the post with 'Dividend Policy', I thought perhaps you would touch on demographics as a factor that could affect such policy within the companies. The aging of the US, and most of the developed world, may well signal an increased demand for dividends, and equity positions in those companies believed to be able to raise them with time. Fears of inflation could bias policy as well.

Buying for a dividend isn't replaceable with a bond if part of the purchase rational is the expectation of dividend growth.

Davi Simon said...

Just one extra argument, on the lemonade business, the buyback was not forced upon the seller.
By that, I reason that the seller was interested in selling.
Win win situation.

On the other hand, management could be improving future earnings per share of remaining stockholders. That seems like a good policy.

It seems like a question of perspective.

In Brazil, we have also stocks-in- treasury, a specific situation in which a Company buys its own shares in order to trade them in the future.

Kind regards, from Porto Alegre,

Davi Simon

Jason DaCruz said...

Bank of America seems to be under pressure to raise its dividends to make its stock more attractive in the short term, but has just been asked by the Treasury to re-think its track. Can we blame BofA's inability to stay profitable on one-off write downs? Or is its business really deterioriating?

I ask this because its announcement to change dividend policy sent the stock down nearly 2%. That seems a bit overstated - and I'd be interested to weigh expected cash returns from the stock against its expected business growth. I don't know exactly how to separate the two, however.