Session 24: Dividend Policy - Trends & Measures

Summary

In this session of a corporate finance class, the instructor discusses the principles of dividend policy, explaining how companies determine and adjust dividends. Key concepts include the sticky nature of dividends, the relationship between dividends and earnings, and the impact of tax laws on dividend distributions. The instructor also highlights the shift from dividends to stock buybacks, influenced by management compensation and economic uncertainties. Finally, he introduces the dividend payout ratio and dividend yield as critical measures for assessing dividend policies, emphasizing the importance of analyzing these metrics over time to understand a company's financial health.

Takeaways

• 📊 Companies exhibit a 'sticky' dividend policy, showing reluctance to change dividends frequently.
• 🔍 The dividend principle states that if investments do not exceed the hurdle rate, cash should be returned to shareholders.
• 💸 Dividends tend to follow earnings rather than lead, meaning companies may delay dividend increases until they confirm long-term profitability.
• 📈 A significant trend is that stock buybacks have become more common than dividends in the U.S. since the late 1980s.
• ⚖️ Tax laws can significantly influence dividend policies, as seen with the changes made in 2003 that aligned dividend and capital gains tax rates.
• 🌍 Differences in dividend policies exist across countries, often influenced by local tax laws and corporate governance practices.
• 🔄 Companies that pay high dividends often exhibit lower expected growth rates, while high-growth companies typically pay lower dividends.
• 🔑 Two key measures of dividend policy are the dividend payout ratio (percentage of earnings paid as dividends) and the dividend yield (dividends divided by stock price).
• 📅 It’s essential to analyze both the current and historical payout ratios and dividend yields when evaluating a company's dividend policy.
• 🧩 The life cycle of a company impacts its dividend policy: startups often pay no dividends, while mature companies are expected to return more cash to shareholders.

Q & A

What is the primary focus of session 24 in the corporate finance class?

The primary focus is on establishing the foundations for dividend policy, particularly how companies set and change dividends, and introducing two key measures of dividend policy: the payout ratio and the dividend yield.

What does the dividend principle state?

The dividend principle states that if a company cannot find investments that exceed its hurdle rate, it should return cash to its owners, either through dividends or stock buybacks, depending on shareholder preferences.

Why are dividends described as 'sticky'?

Dividends are described as 'sticky' because companies are generally reluctant to change their dividend payments. Historically, most companies do not increase or decrease dividends each year.

How do dividends tend to respond to changes in earnings?

Dividends tend to follow earnings; they do not lead them. Companies typically wait to ensure that earnings have increased over the long term before changing dividend payments.

What major tax change occurred in 2003 regarding dividends?

In 2003, the tax rate on dividends was equated to the tax rate on capital gains, both being taxed at 15%. This significant change led many companies, including Microsoft, to institute dividends for the first time.

What trend has been observed in the methods companies use to return cash to shareholders?

Over the past 25-30 years, there has been a significant shift from paying dividends to stock buybacks as the primary method of returning cash to shareholders, with stock buybacks becoming more prevalent since the late 1990s.

What might explain the increase in stock buybacks over dividends?

One reason for the increase in stock buybacks could be the shift in management compensation structures towards options, which can lose value when dividends are paid. Additionally, companies may feel less confident about future earnings, making them hesitant to commit to paying dividends.

How do dividend policies vary across different countries?

Dividend policies can vary significantly across countries due to differences in tax laws and corporate governance. For example, UK and Australian companies tend to pay more dividends because of favorable tax treatment, while companies in Russia tend to pay less due to poor corporate governance.

What are the two key measures of dividend policy mentioned in the session?

The two key measures of dividend policy are the dividend payout ratio, which indicates the percentage of earnings paid out as dividends, and the dividend yield, which is calculated by dividing dividends by the stock price.

How do a company's life cycle stages influence its dividend policy?

In the early stages of a company's life cycle, especially for growth companies, dividends are generally not paid. As companies mature and their reinvestment needs decline, they are expected to start paying dividends. In declining companies, dividends may exceed earnings as part of a liquidation strategy.