The first article in this series emphasised that dividends are best understood through cash flows rather than through stated earnings, which are intangible since they are simply an accountant’s opinion.
Using the cash flow framework also helps us better understand dividend policy – how companies decide when and how much to pay in dividends.
In the mix
When we boil it down, companies can do four things with their cash flow:
1. Save it (cash and equivalents, pay down debt)
2. Spend it (acquisitions and so on.)
3. Reinvest it (new projects, expansion projects)
4. Distribute it (dividends, buybacks)
With a finite amount of cash flow each year, companies must decide how much cash each of these buckets receive. These decisions are driven by, among other things, the company’s stage in its growth cycle, its financial health, the tax environment, and what its shareholders want.
Capital allocation is the number one responsibility of a company’s leadership team. Strong capital allocators can compound a company’s growth rate and create more shareholder value; conversely, a team of poor capital allocators can lead a once-solid company into a sluggish existence.
Ultimately, we want to identify companies with management teams that have made wise capital allocation decisions in the past.
A company that is generating high returns on equity, for example, and can reinvest all of its cash in projects that produce returns well above the cost of equity should, in theory, do just that — reinvest all the cash.
Investors should want this, too, in lieu of a dividend, as it maximises shareholder value.
If the company can take the cash and invest it at 20%-plus returns, so be it!
More money, more problems
These are rare cases, however, and more often than not companies in the mature and mature-growth stages do not have enough value-enhancing projects for all of the cash they generate.
When this happens, the company’s board considers alternative uses for the extra cash flow.
In a situation where the board expects the extra cash flow to be a one-time event, they may declare a special one-time dividend or buyback shares. On the other hand, if they expect there will be extra cash flow year after year, they may establish a regular dividend programme where a portion of the company’s cash flow is returned to shareholders periodically throughout the year.
If these sound like over-simplified examples, you’re right. Dividend policy decisions are normally not so straightforward, but it’s important to first understand the core theory behind why companies pay dividends.
In the real world, shareholder preference and peer behaviour can complicate the process.
Pleasing the masses
Three important theories on dividends can help us understand why different companies’ shareholders have varying interests in dividends:
1. Dividend irrelevance
2. Tax aversion
The dividend irrelevance theory is based largely on the important research done by Miller and Modigliani who reached the conclusion that in a world of no taxes, no investment costs, rational investor behaviour, and infinitely divisible shares that dividends should be irrelevant to shareholders.
If an investor wants cash, the theory maintains, he or she can simply sell a few shares and create their own dividend.
This theory might sound naïve given all the unrealistic assumptions it involves, but many investors subscribe to it! Institutional owners in particular, who tend to have a larger number of shares, can more easily create their own dividend without incurring a high percentage of trading costs, and thus may prefer lower dividends.
Such “homemade” dividends make less sense to individual investors, due to the more prohibitive trading costs.
Assuming you want to keep trading costs below 1% and that you pay £10 commissions, you’d need to sell at least £1,000 worth of your position each time to create your own dividend and keep costs in check. Whilst not out of reach for some wealthy individual investors with large positions in a particular share, it’s certainly less realistic for the average investor.
Like trading costs, taxes reduce realised returns. Naturally, then, the tax aversion theory states that investors with higher tax rates should prefer to own shares that pay lower dividends or none at all.
This can be particularly true in countries where the capital gains rate is well below the dividend tax rate. In such a circumstance, it stands to reason that companies that pay high levels of dividends should attract investors in lower tax brackets or tax-exempt institutional investors.
The bird-in-hand theory was developed by Myron Gordon and John Lintner and takes its namesake from the proverb that “a bird in hand is worth two in the bush.”
As the proverb suggests, an investor should prefer to have cash in hand today rather than uncertain capital gains down the road. As such, investors place a higher value on dividends than future capital appreciation.
In addition, the more-certain cash from dividends, the bird-in-hand theory contends, reduces the cost of equity that investors place on the share. The lower the cost of equity, all else being equal, the higher the value of the share.
Of the three, dividend-loving investors most frequently subscribe to the bird-in-hand theory. Understandably so.
Still, it’s important to recognise that the majority of a company’s shareholders may not have the same sentiment, and may prefer the company reinvest in its operations, to buyback shares, or to make an acquisition instead.
Policies are not created equal
Once a company has decided that it will pay a dividend, it can either adopt a (what I’ll call) “firm” or “loose” dividend policy.
A firm dividend policy is one in which the company spells out in detail its plans for future payouts (i.e. “a progressive payout with a target dividend cover of at least 2 times”).
Conversely, in a loose dividend policy the company does not explain its decision-making process behind the dividend payments.
All else being equal, dividend-focused investors should prefer to own companies with a firm dividend policy because they provide more transparency.
If a firm does not explain its policy, there may be less commitment from the board and the framework for deciding each year’s payout can change year to year, leading to greater uncertainty.
Dividend policy in summary
A company’s dividend policy provides tremendous insight into its relationship with shareholders, and can help us better understand management’s strategy for enhancing shareholder value.
If a company has a loose dividend policy, lacks a track record of paying dividends, and has consistently bought back shares at high prices, it might be best to look elsewhere for dividend income.
You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.
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