The dividend policy is a policy that is generally reported to shareholders but it is rarely explained to them. A company usually reports, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI.”
Managers and owners should think about why earnings should be retained and why they should be distributed.
The first point to understand is that all earnings are not created equal. In companies with high asset/profit ratios and inflation, some earnings become ersatz. Such a portion of earnings is not distributed as dividends, if the company intends to retain its economic position.
If earnings are paid out as dividends, the business will be affected in its ability to maintain its unit volume of sales, its long-term competitive position and its financial strength.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential.
Now, what about the much-more-valued unrestricted variety? They can be retained or not. The decision of management should depend on what makes greater sense for the owners of the business. This principle is not universally accepted, though.
For a number of reasons, managers like to withhold unrestricted, readily distributable earnings from shareholders — to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. However, there is only one valid reason for retention: if there is evidence that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
For example, let's say an investor owns a risk-free 10% perpetual bond that has the characteristic that every year the investor can choose to cash it 10% or reinvest it in more 10% bonds under identical conditions. If, at a given point, the prevailing interest rate on long-term, risk-free bonds is 5%, it would have no sense for the investor to cash its bond. It would be better for him to take this percentage in additional bonds and sell them immediately. By doing that, he would realize more cash than if he had taken his coupon directly in cash.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
This is an analysis considered appropriate for owners when thinking whether earnings should be retained or paid out. Of course, this analysis in the real world is much more difficult.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners.
But in this case, the situation is a bit different. Managers do not usually like to put themselves in the place of shareholder-owners.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere.
In such cases, shareholders would prefer to have earnings retained to expand the business. The balance may be paid out in dividends or used to repurchase stock.
Shareholders at public corporations prefer to have consistent and predictable dividends. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital.
Generally speaking, the long-term corporate outlook seldom changes, thus the dividend patterns should follow the same path. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Managers and owners should think about why earnings should be retained and why they should be distributed.
The first point to understand is that all earnings are not created equal. In companies with high asset/profit ratios and inflation, some earnings become ersatz. Such a portion of earnings is not distributed as dividends, if the company intends to retain its economic position.
If earnings are paid out as dividends, the business will be affected in its ability to maintain its unit volume of sales, its long-term competitive position and its financial strength.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential.
Now, what about the much-more-valued unrestricted variety? They can be retained or not. The decision of management should depend on what makes greater sense for the owners of the business. This principle is not universally accepted, though.
For a number of reasons, managers like to withhold unrestricted, readily distributable earnings from shareholders — to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. However, there is only one valid reason for retention: if there is evidence that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
For example, let's say an investor owns a risk-free 10% perpetual bond that has the characteristic that every year the investor can choose to cash it 10% or reinvest it in more 10% bonds under identical conditions. If, at a given point, the prevailing interest rate on long-term, risk-free bonds is 5%, it would have no sense for the investor to cash its bond. It would be better for him to take this percentage in additional bonds and sell them immediately. By doing that, he would realize more cash than if he had taken his coupon directly in cash.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
This is an analysis considered appropriate for owners when thinking whether earnings should be retained or paid out. Of course, this analysis in the real world is much more difficult.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners.
But in this case, the situation is a bit different. Managers do not usually like to put themselves in the place of shareholder-owners.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere.
In such cases, shareholders would prefer to have earnings retained to expand the business. The balance may be paid out in dividends or used to repurchase stock.
Shareholders at public corporations prefer to have consistent and predictable dividends. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital.
Generally speaking, the long-term corporate outlook seldom changes, thus the dividend patterns should follow the same path. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
