Every year, a company three options as to what it can do with earnings in order to create value for shareholders:
- Reinvest in the business;
- Pay cash dividends to shareholders; and/or
- Buy back shares.
Note that option 1 assumes that company management profitably reinvests in the company, otherwise value can actually be destroyed.
Keep in mind that paying dividends reduces a company’s retained earnings, which is a reduction to equity in the capital structure.
Dividend Payout Policy
A company’s dividend payout policy is the amount and timing of its dividend payout.
Payout Ratio: The percent of net income that is paid out in dividends (recall that dividends are not expensed and thus not part of the net income calculation).
Example: A company with net income of $100 million pays out $60 million in dividends; therefore it has a payout ratio of 60% or 0.60 and retained earnings will increase by $40 million.
Cash Dividend Policy types include:
Residual Dividend Approach
- This is where a firm does not pay dividends until the equity portion of its capital budget is funded.
- Under the residual approach a firm must determine if attractive (i.e. NPV positive) capital projects exist.
- A disadvantage of the residual approach is that it can lead to inconsistency in dividend payouts, making it difficult for investors to set return expectations.
- When investors have difficulty forecasting returns they may place higher return requirements on equity, which raises the firm’s cost of equity capital.
Longer-Term Residual Dividend Approach
- A version of the simple residual approach, under this policy management designs a capital budget for the next five to ten years, which leads to steadier dividend payments to shareholders.
- Consistent expectations around dividend payments can lower investor required return on equity, which in turn lowers the firm’s cost of equity capital.
Stable Dividend Policy
- Under this approach, management makes a calculation about the firm’s long-term sustainable earnings and announces the payment of stable dividends to shareholders.
- Investors tend to prefer certainty and the stable approach eliminates the inconsistency that can be created by the residual approach.
Target Payout Ratio Approach
- Under this approach, company management creates a long-term strategic goal of paying a certain percentage of corporate dividends out to shareholders in the form of cash dividends.
- In mid 20th century, an academic named Lintner developed a model to show how a company steadily moves toward its target payout ratio.
Expected Dividend Increase = Expected Earnings Increase * Target Payout Ratio * Adjustment Factor
Adjustment Factor = 1 / # of years over which the dividend adjustment occurs
The adjustment factor reduces dividend volatility.
This is the act of a company buying back its common shares. Like dividends, share repurchases require the use of corporate funds.
Sometimes firms buyback shares simply to offset the dilutive effects of issuing stock options to employees.
Firms may issue debt for the purpose of buying back shares. When the after-tax cost of debt exceeds the company’s earnings yield (EPS/share price), then earnings per share will actually drop and the repurchase is dilutive.
Share buybacks can also impact book value per share. If the company pays more per share to repurchase shares than the current book value per share, then the firm’s book value per share will fall.
Reasons that firms buyback shares
- If the company’s management believes that the market is undervaluing its shares, then the buyback can be a quality investment.
- Management may use share buybacks as an attempt to signal a positive outlook to investors.
- Share repurchases can be a means of altering its capital structure.
- Share repurchases can be more flexible than cash dividends. Dividend announcements tend to set regular expectations, while repurchases can be used to return value to shareholders when cash flows are unexpectedly high.