I often get asked this question. People may think that the dividend policy of a company does not really matter. After all, any money not paid out in dividends is retained within the business, so shareholder value is preserved. However this misses important considerations. Over time, dividends represent a large part of the total return shareholders receive from businesses. Dividend policy is a key part of the capital allocation process and it enforces a strong cash discipline on the management team. Dividend policy also conveys a message about the financial health of a business and its future prospects.
I will follow this blog with another, which discusses when companies should and should not cut dividends and the six worst reasons given for cutting dividends.
In essence, I believe, a company should set their ordinary dividend at a level that reflects the sustainable, surplus cash generation of the business through the cycle. The dividend policy should follow from the cash needs of a business and not the other way around. Dividends should not be set in isolation, or in order to meet an arbitrary yield or dividend growth requirement. Ordinary dividends may be supplemented by special dividends or share buy-backs when companies have accumulated excess cash that is surplus to immediate requirements as discussed below.
Looking at this issue in more detail; Companies have many competing demands on the money they generate from sales of products and services. The first priority of a management team is to keep the company in financial health and competitive. Cash must be allocated to pay all operating costs, interest, tax and so on. A company also needs to maintain the fabric of its infrastructure, invest in research and new product development, maintain a competitive technology base and upgrade systems, facilities and other capabilities.
Beyond these requirements, expenditure is more discretionary. Companies can spend money in 4 broad categories; Enhancing organic growth of the business, acquiring other businesses or assets, strengthening the balance sheet or returning money to shareholders via dividends or their capital returns.
Enhancing Organic Growth
Normally there are good reasons for companies to invest in organic growth. To the extent that a company has a competitive advantage, it may be able to exploit this advantage in a larger part of the market, into adjacent markets or into new geographic areas. If the company can earn a return above its cost of capital, then this investment will add value and should normally be welcomed. This is not to say that all investment is good investment. The recent history of the oil and gas industry or UK supermarkets shows how considerable shareholder value can be destroyed by companies over-investing at the wrong stage in the cycle, or putting surplus capacity into an industry undergoing structural changes. However, as a general rule, a certain level of investment for organic growth should be a priority for most businesses.
It is harder to generalise about acquisitions. Certain companies make regular ‘bolt-on” acquisitions, especially those that are consolidating a fragmented industry. These purchases are typically low risk, highly likely to succeed and usually value accretive. Such acquisitions should be supported and it is reasonable for companies to set aside money regularly for this purpose.
Larger, transformational acquisitions or mergers carry greater risk but potentially higher returns. It is hard to generalise about whether large deals are good for shareholders, but I do not think companies should run excessively conservative balance sheets in case such an opportunity arises. They should use a combination of debt and new equity to make large acquisitions, provided the purchase makes strategic and financial sense. So, in summary, apart from setting aside cash for regular small acquisitions, companies should not hold back money for occasional large deals.
Strengthening the balance sheet
It is critical that companies have robust balance sheets. The word “Equity” used to describe shares in a company has the same meaning as the equity that mortgage holders have in their home. Homeowners understand that their home is at risk if they are unable to make mortgage interest payments or capital payments. Their equity can also be wiped out if the value of the house falls too far. It is the same for companies. Shareholders’ equity can be wiped out if a company has excessive debts and can’t meet its financial liabilities. So it is a priority that sufficient cash flows in a company are allocated towards keeping the balance sheet within an optimal range.
The balance sheet must not be too weak, but it should not be too strong either. A certain amount of debt is appropriate for most companies both for tax efficiency and to leverage the equity returns.
Returning money to shareholders
Only once a company has addressed the three issues above, should the board consider returning excess money to shareholders. Companies should first allocate money for organic growth opportunities, regular (small) acquisition expenditure and balance sheet management.
There is much debate about whether dividends are better than share buy-backs, especially in the USA where tax treatment of dividends is different. In theory, if shares are bought back below their intrinsic worth, then the per-share value of the company increases for the shareholders who do not sell shares in the buy-back. However, in practice, many shares are bought back at inflated prices, often when profitability is cyclically high. When this happens, the selling shareholders benefit at the expense of the remaining shareholders. The focus on earnings per share multiples, which often encourages buy-backs, can lead to poor allocation of capital and fuzzy thinking about a fair price for buying back stock. Another problem with regular buy-backs is that the only way for shareholders to receive income is to sell part of their holding.
I have a strong preference for companies to set an ordinary dividend at a level that can be sustained throughout the economic and industry cycle. It is not always easy for companies to know what is sustainable so it is better to err on the side of caution. When assessing the right level for dividends, companies should consider the cyclicality of the business and the strength of the balance sheet. Cyclical companies can allow gearing to increase in the trough years of a cycle, whilst they maintain dividend payments, provided there is a reasonable expectation that cash flows will improve in the future, and also that the balance sheet is not threatening the financial viability of the business. The oil majors are going through this process at the moment and adjusting capital expenditures to ensure that their businesses can once again balance cash outgoings with net income1.
When companies set this type of policy, investors understand that dividends should be maintained in most situations and the dividend yield can provide a backstop to the valuation. It focuses the mind of management on sustainable cash generation.
For relatively stable businesses the ordinary dividend should be set at a level where gearing is maintained within an optimal range, or perhaps reduces slightly each year to allow for unexpected minor cash demands.
Should companies build up surplus cash beyond what will be repaid via ordinary dividends, they can consider making occasional special payments, either as dividends or buy-backs. In this case, I prefer to see special dividends unless shares are trading below their fundamental worth, although this can be a hard judgement to make.
If a company follows this policy then dividend cuts should be quite rare and would normally reflect a significant, unusual and potentially prolonged downturn in operating performance, or possibly a major unexpected cash outflow, for example relating to legal charges or product defects.
In my next blog I look at dividend cuts and compile my list of the six most unacceptable excuses.
1. This is no recommendation to buy or sell any particular security