Session 24: Dividend Policy - Trends & Measures

In session 24 of this 36-session corporate finance class, I'd like to lay the foundations for dividend policy. In particular, I'd like to characterize how companies set and change dividends, but I'd also like to introduce two measures of dividend policy, the payout ratio and the dividend yield. So now that we've laid out the pieces of the financing principle, and we've looked at the investment principle, we're on to the third and final principle in corporate finance, which is the dividend principle. So in this session, what I'd like to do is set up some facts about dividend policy, describe how companies set dividends, because it's useful in understanding why a company might have the dividend policy that it does. So let's get the process rolling. Let's think about the dividend principle. Revisiting the principle, here's what it says. If you cannot find investments that make a return that exceeds your hurdle rate, give the cash back to the owners of the business, right? Common sense principle. Whether you do it in the form of dividends or stock buybacks will depend on what your stockholders prefer, and that's something we have to come back and re-examine. So let's look at how we put the dividend principle into practice by looking at the steps involved before you get to the dividend decision. So if you're a company, you start off by looking at cash flows you get from your projects, right? Some of those cash flows are going to go to your lenders because you've contractually obligated yourself to make those payments, and you have cash flows that are available to be returned to equity. Some of those cash flows that are available to be returned get reinvested back into the business, and you get to decide as management how much you reinvest, which is going to leave you with a residual cash balance. Cash that you can potentially return as dividends, but you don't have to. You might choose to hold back some of that cash as a cash balance, and what's left is what you end up returning to stockholders. And there again, you have a choice. You can either return it as dividends or stock buybacks. So keep these steps in mind as you think about some of the characteristics of how companies pay and change dividends. If there's a word I would use to describe dividend policy across the world, it is that it's sticky. What I mean by that is companies are very reluctant to change the way they pay dividends. The best way I have of showing this fact is by looking at what U.S. companies do in terms of changing dividends each year and going back all the way to 1988. So if you look at this graph, what you have are three columns. The first column, which is the dark yellow column, are the percentage of companies each year that do nothing to dividends. Notice that in every single year, that column is by far the tallest column. Most companies in most years pay exactly what they did in the previous year in dividends. That's what I mean by sticky. So most companies are reluctant to change dividends. In the U.S. and Europe, companies tend to be sticky about dollar dividends or euro dividends, about absolute dividends. In Latin America, they tend to be sticky about dividend payout ratios. Payout ratios being the percentage of earnings you pay in dividends. So in Latin America, companies will pay out 30% of their earnings as dividends and try to stick as close as they can to that number. One more aspect of this graph that I want to draw your attention to before we move on. It is true that in every year that we look at this data, more companies do nothing to dividends than either increase them or decrease them. But if you look at only the companies that change dividends, notice that in every single year, the number of companies that increase dividends vastly outnumber the companies that decrease dividends. Companies, if they change dividends, are far more likely to increase them than decrease them. So that's the first aspect of dividend policy to keep in mind. Here's the second one. Dividends tend to follow earnings. Key word is follow. They don't lead earnings. They're not contemporaneous with earnings. They follow earnings. You say, what does that mean? Let's say you have a company that has a really good year in terms of earnings. Its earnings go up 30%. What this graph tells you is don't expect to see a dividend increase that year. Let's say the company has two good years in a row. Maybe you'll see a dividend increase next year. There's three good years in a row. You'll probably see a dividend increase in year three. Companies wait to make sure that their earnings have in fact gone up for the long term before they go out and change dividends. So dividends are sticky. Dividends tend to follow earnings. Here's the third aspect of dividends. Remember, as an investor in a company, you get money in two ways from your investment. First is you get dividends. The other is price appreciation. And for whatever reason, the tax law sometimes treats these two sources of income differently. In the US, for instance, from 1913 all the way up through 2003, dividends were taxed at an ordinary tax rate, which is usually much higher than the tax rate paid on capital gains or price appreciation. So until 2003, you had a tax disadvantage associated with dividends. In 2003, for the first time in a century, the tax rate on dividends was equated to the tax rate on capital gains. They were both taxed at 15%. Monumental change. And in 2003, you saw a large number of companies institute dividends for the very first time. In fact, Microsoft paid a $33 billion dividend in the quarter after the tax law change. So tax laws do affect dividends. In fact, that 2003 tax law was designed to sunset on December 31st of 2012. In fact, on January 1st of 2013, tax rates could very well have gone up to what they were in 2002. So leading into December of 2012, you had a lot of talk about the fiscal cliff. The potential, at least, that tax laws could go back to the way they were pre-2003. Not surprisingly, you saw a lot of companies pay special dividends in the last quarter of 2012, leading up to an expected tax law change. So if tax laws change, don't be surprised to see dividend policies change to reflect them. Here's the fourth aspect of dividends. And this, to me, is a very striking trend in dividends for the last probably 25 to 30 years. In the early 1980s, the predominant way that companies had for returning cash to stock holders was dividends. Very few companies bought back stock. Somewhere in the mid-1980s, you started to see U.S. companies start to buy back stock. But even in 1988, when this graph starts, you see twice as much cash return in the form of dividends as was paid out in stock buybacks. But through the 1990s, you see the stock buyback line climbing. And in 1998, for the very first time in U.S. corporate history, as much cash was returned in the form of buybacks as was paid out in dividends. And every year since, except for 2009, stock buybacks have been a bigger way of returning cash than dividends have, which raises an interesting question. Why is this happening? Well, one reason might be that management compensation was increasingly tilted towards options in the 1990s. You might say, so what? If U.S. managers get rewarded with options or compensated with options, you don't want to pay dividends because when you pay dividends on the ex-dividend day, the stock price will tend to drop by the amount of dividends, which makes your options less valuable. You'd much rather buy back stock. So one reason for the shift towards buybacks might be the change in compensation structures. But there's another more fundamental reason. Remember the word we used to describe dividends as sticky? In other words, if you increase dividends, you're stuck paying those dividends. You're saying, so what? Well, let's say your earnings go up, but you're not very confident that they will stay up. You're not going to increase dividends, right? So the greater the confidence you feel about future earnings, the more likely it is that you will pay high dividends. And I would argue that companies are getting less confident about future earnings than they used to be, partly because of globalization. You have much more competition from overseas, and partly because there are fewer and fewer sectors which are protected by the government or by other entities from competition. In effect, companies are getting much less certain about future earnings. And because they're getting much less certain about future earnings, they're buying back more stock. In fact, I liken paying dividends to getting married and buying back stock to hooking up. Effectively, companies are hooking up a lot more than they used to because they don't feel confident about long-term relationships with their stockholders anymore. Which leaves me with a final description of dividends. And if you look across countries, you notice big changes or big differences in dividend policy. For instance, UK and Australian companies have tended to pay more dividends than companies in other countries. And there's a good reason for that. In the United Kingdom and Australia, investors are allowed to claim a tax credit when they receive dividends for taxes the company might have paid before it paid those dividends. So if you're a stockholder in the UK, Australia, you might actually pay no taxes on dividends because of that tax credit. The tax laws are tilted towards dividends. Not surprisingly, you see more dividends paid in both countries. In Russia, if you notice, far less is paid out in dividends. The reason for that, I think, is the poor corporate governance in Russia. Put differently, managers left to their own instincts will tend to hold on to cash. Because remember, once they pay the cash out, they don't control it anymore. So in countries with weak corporate governance, I would expect to see far less paid out in dividends. So those are things to keep in mind when you think about dividend policy and why it might be different across companies and why it might change over time. Now let's talk about measuring how much a company pays in dividends. There are two measures of dividend policy out there. The first is called the dividend payout ratio, the percentage of earnings that you pay out in dividends. What does it tell me? It tells me how much of my earnings are being put back into the company. It essentially is a measure of what you pay out and what you retain. The other measure of dividends is the dividend yield, where you divide the dividends by the stock price. That tells me how much of my return I'm going to get from dividends. And if you remember our earlier discussion of expected returns on stocks, this is the portion of that return that comes from dividends. The dividend payout ratio or the dividend yield. Let's say you compute both numbers for your company. Once you compute those numbers, I'll wager you're going to look at those numbers and have no sense of whether they're high numbers, low numbers, or average numbers. So let me give you some frames of reference. If you're looking at dividend payout ratios, here's the distribution of dividend payout ratios across all companies at the start of 2014. Let me take that back. It's across all companies that pay dividends in early 2014. You have both U.S. companies and global companies in here. The median payout ratio for U.S. companies is about 25 to 30 percent. The median payout ratio for a global company is about maybe 30 to 40 percent. Not that much difference across companies. So when you see a company pay out 60 percent of its earnings in dividends, it is paying out more than the typical company. Notice there are a few companies that pay out more than 100 percent of their earnings in dividends. They're not necessarily irrational. They might be companies having a bad year. They might be companies partially liquidating themselves over time. Or they might be companies where the cash flows are much greater than the earnings. So don't be surprised to see payout ratios that look odd in any given year. And notice how I characterize this graph. I said this is the distribution of payout ratios of companies that pay out dividends. The reason I emphasize that is last year in 2013, out of the 7,800 companies I have in my U.S. data sample, 4,500 paid no dividends. The median payout ratio across all U.S. companies is actually zero percent. The typical U.S. company actually does not pay dividends. That's why it's useful to separate your sample into dividend-paying companies and non-dividend-paying companies. Now let's look at the dividend yield. The median dividend yield for a U.S. company now is about 2 percent. That's down from about 3.5 to 4 percent maybe 30 years ago. That reflects the shifting of U.S. companies increasingly from paying dividends to stock buybacks. What it also tells you is if you invest money in stocks, don't expect to make the bulk of your returns from dividends, even though there are a few stocks out there with dividend yields of 4, 5, or 6 percent. Most stocks, if you make money, you're going to make it off price appreciation, not off dividends. So to close the process, let me look at the life cycle. Remember we used this to make a judgment about how much companies should borrow? I can use the life cycle to make a judgment of how much companies should pay out in dividends. So let's look across the life cycle. If you're a young growth company or a startup, how much should I expect you to pay in dividends? Well, I would expect no dividends. And there's a simple reason for that. Early in the process, you're losing money. If you're losing money, you have no business paying dividends. Later in the growth process, you're making money, but every dollar you make is going to go back into the business to create future growth. You should still not be paying dividends. As you mature as a company, your earnings continue to grow, but your reinvestment needs to fall off. Remember that's when your debt capacity opens up? That's exactly when your capacity to return cash also opens up. And just as you will fight borrowing money, you will tend to fight paying out dividends, which means that when growth companies start to mature, you should start to see cash balances balloon out as they did in Apple or Google or other tech companies when you saw their growth rates start to level off. Once they become mature companies, they should return even more in dividends. And if you're a declining company, you're actually partially liquidating yourself over time. I should expect to see dividends that actually vastly exceed your earnings because over time, you want to make yourself smaller. So you tell me where you are in this life cycle, I can make a judgment on what kind of dividend policy I would expect you to have. Now, looking across companies, you see some backing for this life cycle concept because what I've done in this graph is broken down companies based upon their expected growth in the future. And I get the expected growth rates by looking at analyst projections of growth. And then I look at what percentage of earnings companies within each growth class tend to pay out as dividends, either as a payout ratio as a dividend yield. No surprises here. The higher the growth rate of a company expected growth, the lower the payout ratio and dividend yield tend to be. So as companies' growth prospects improve, you should expect these companies to pay out less in dividends, buy back less in stock, and in general, return less cash to their stockholders. So as a closing table, let's look across the five companies, the public companies we have in our sample. In this table, I've shown you what the dividend yield and payout ratios are for each of these companies in 2013. And there are a couple of numbers that jump out at you, right? Vale and Deutsche Bank seem to be returning more than their earnings as dividends. But before you freak out, take a look at the average yield and payout ratio across the last five years, because I think that's a much better number to focus on. Vale's average payout ratio, looking across the five years, is only 37%. How do you explain 2013? But 2013 was not a very good year. Commodity prices, the earnings went down. But if you're a commodity company, you don't base your dividends on what happened during a particular year. You base it on what you can afford to pay out during a normal year. So what I'm effectively arguing for in this particular table is take a look at the dividend yield and payout ratio of whatever company you're assessing, but also look at what that number looks like over time, because that might be a better number to focus on than any individual year's dividend yield or payout ratio. It's a good place to start assessing dividends, and we'll come back to make much more serious assessments of how much a company should return in the next few sessions. Thank you very much for listening.