Dividend policy refers to the guidelines a company uses to decide how much of its earnings it will pay out to shareholders in the form of dividends.
Companies have a range of dividend policies to choose from, and the choice depends on a multitude of factors.
The selection of a dividend policy has a significant impact on the financial structure, the flow of funds, corporate liquidity, stock prices, and investor’s satisfaction.
Key Takeaways – Dividend Policy
- Dividend Policy’s Impact: Dividend policy determines how much of a company’s earnings are paid out to shareholders. It affects financial structure, stock prices, and investor satisfaction.
- Models Inform Choices: The Walter, Gordon, and Lintner models offer insights into dividend policy decisions based on growth opportunities, cost of capital, and stability.
- Complex Factors at Play: Dividend policy involves balancing investor preferences, tax implications, growth needs, and market perceptions, shaping a company’s financial trajectory and relationships.
Dividend Policies in Corporate Finance
Dividend policy is a significant aspect of corporate finance.
It revolves around three primary questions:
- What proportion of earnings should be paid out to shareholders?
- How should these payments be structured?
- And when should dividends be paid?
Answering these questions allows a company to establish a predictable pattern, which can help attract and retain investors.
The Walter Model, named after economist James E. Walter, provides a theoretical framework to understand the impact of a company’s dividend policy on its value.
According to this model, the choice of dividend policy depends on a company’s investment opportunities and the cost of capital, suggesting that firms with high growth opportunities should retain more earnings, while low-growth firms should distribute it back to shareholders (who then will by more shares, other financial assets, or spend it).
The model asserts that companies can maximize their market value by balancing dividends and growth.
The Gordon Model, also known as the Gordon Growth Model or Dividend Discount Model (DDM), is another dividend valuation model, and perhaps the most popular.
Developed by economist Myron J. Gordon, this model suggests that a company’s market value is determined by its dividend policy, rate of return, and growth rate.
The model implies that if the internal rate of return is greater than the cost of capital, the company should retain earnings, while if the cost of capital is higher, the company should pay dividends.
John Lintner proposed another model for understanding the dividend policy and its impact on a company’s value.
The Lintner Model suggests that companies focus on providing stable dividends, aiming for a consistent growth rate in dividends, and making adjustments slowly to changes in earnings.
This model reflects the fact that many companies are reluctant to decrease dividends and would rather maintain a consistent dividend payment policy.
Generally speaking, dividends represent the portion of a company’s earnings that are “guaranteed” (i.e., the market signal). So if a company cuts its dividend (or the market prices in that reality), the stock is generally punished accordingly.
The Residuals Theory of dividends is an approach where a company uses residual or leftover earnings after all expenses, reinvestments, and debt repayments to pay out dividends.
In this policy, dividends are seen as secondary to investment opportunities – only when the company’s investment needs are met does it distribute dividends.
This approach implies that a company’s dividend payout could vary significantly from one period to another, which may not appeal to investors seeking predictable income.
The Clientele Effect refers to the tendency of a company to attract the kind of investors who like its dividend policy.
For example, growth-oriented investors might prefer companies that retain more of their earnings to invest in future growth, while income-focused investors may prefer companies with a regular and substantial dividend payout.
Understanding the Clientele Effect is essential for a company while determining its dividend policy as it affects its investor base.
The Clientele Effect: Retail vs. Institutional
Individual investors generally prefer higher dividends because they use dividend stocks and interest- or income-paying investments to eventually replace their income so they have the option to retire.
REITs, MLPs, and BDCs are not taxed in exchange for distributing 90% of their earnings to shareholders. This accounts for their traditionally high yields.
Institutional investors, however, don’t necessarily have a dividend type of focus.
Are REITs, MLPs, and BDCs only required to pay out 90% of their earnings in dividends in the US or does it apply to other countries too?
In the US, certain types of investment entities, such as Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and Business Development Companies (BDCs), have specific regulatory and tax frameworks that require them to distribute a substantial portion of their income to investors.
This framework is designed to pass through most of the income (and consequently, tax obligations) to the shareholders or unitholders.
For each entity in the US:
- REITs: To qualify as a REIT and benefit from a special tax status, at least 90% of its taxable income must be distributed to shareholders as dividends. This enables the REIT to avoid paying corporate taxes at the entity level.
- MLPs: While the 90% figure is commonly associated with REITs, it’s a bit different for MLPs. MLPs are partnerships that are publicly traded. They don’t pay federal income taxes at the entity level if they earn at least 90% of their income from qualified sources, such as natural resources activities. But this doesn’t mean they must distribute 90% of their income.
- BDCs: Business Development Companies operate in a manner similar to REITs in terms of distribution requirements. To avoid paying income tax at the corporate level, BDCs are required to distribute at least 90% of their taxable income to shareholders.
As for other countries, the regulatory and tax landscape for entities similar to REITs, MLPs, and BDCs can vary significantly:
- Many countries have their versions of REITs, often with distribution requirements. For example, the UK has Real Estate Investment Trusts that also need to distribute the majority of their income to enjoy beneficial tax treatment, but the specifics might differ from the US.
- The concept of MLPs and BDCs is more unique to the US, so you won’t find an exact replica in other jurisdictions. However, similar structures or investment vehicles may exist with their own set of rules and tax implications.
If you’re considering investing in such entities outside the US or setting up a similar structure, it’s necessary to consult local regulations and perhaps seek legal or financial advice in that specific country.
Dividends are subject to tax, and this tax implication plays a role in a company’s dividend policy.
Dividend tax can influence investor preferences and determine whether they prefer dividends or capital gains.
Companies must consider these tax implications while setting their dividend policies to maximize investor returns.
The Dividend Puzzle is a term coined by economist Merton Miller to describe the paradox where despite dividends being subject to taxation, investors still prefer companies paying them relative to share buybacks, which are taxed via long-term capital gains (for those holding the stock for greater than one year).
If investors prefer dividends over buybacks despite the tax arbitrage argument for buybacks (it depends), then prioritizing dividends could make more sense.
This puzzle illustrates the complexities in understanding investor preferences and the ongoing debate about the relevance of dividend policies.
Treasury Stock and Buying Back Shares
One method for a company to distribute cash to shareholders is to buy back its own shares, which is also known as treasury stock.
This approach can increase the company’s share price and provide tax benefits to shareholders, as share buybacks are usually taxed at a lower rate than dividends (normally taxed as ordinary income).
However, this method can lead to shareholder concerns about company management using buybacks to manipulate earnings per share.
The dividend policy a company chooses significantly impacts its investors, its access to capital, and its growth opportunities.
Given the numerous theoretical models and real-world complexities, it is crucial for companies to strike a balance between investor preferences, growth opportunities, tax considerations, and market perceptions.
Understanding and developing an effective dividend policy is an important aspect of corporate finance that can shape a company’s financial future and its relationship with investors.