My previous blog, How should a company set its dividend policy? outlined my view that a company should set its ordinary dividend at a level that reflects the sustainable, surplus cash generation of the business through the cycle. If this is the case, then dividend cuts should be quite rare, and should only occur in certain situations.
Dividend cuts may be justifiable and necessary if trading profits have permanently deteriorated to a level where the payout is unsustainable, or where a large, unexpected cash outflow has impaired the balance sheet. However in practice dividend cuts are more common than might be expected. Very often the reasons cited are surprising and possibly even baffling.
In the list below I show the six worst reasons I have seen companies give for cutting dividends, with a brief explanation of each. These are arranged in reverse order with the number one, most unjustifiable reason, at the bottom.
Poor reasons for dividend cuts:
6 – “We can set a lower base and then grow dividends again”. Companies like to show growing dividends. For some, this means they are willing to reduce the dividend in order to grow it in future. If a company really needs to cut the dividend this is fine. However, if the company is financially strong enough to hold the dividend flat for several years, that would be my preference over a “rebase to grow” strategy.
5 – “Profits have fallen compared to last year”. Normally a dividend policy should be able to cope with some volatility in short term performance. Only if the dividend is no longer sustainable on a long term view should the payout be cut.
4 – “The payout ratio has moved above our target range”. Similar to excuse number 5, dividend policy should be set in a way that allows for short term profits volatility. If a payout ratio is stated, it should be justified in terms of the ongoing cash needs and variability of the business. If a breach then occurs the dividend policy will logically be called into question.
3 – “We have a new chief executive”. Dividend policy should be set by the company’s board, not any individual executive director. A new CEO may have a different view on the appropriate dividend from their predecessor, and they may have a different strategy for the company, but it should be the strategy and outlook that determines dividend policy. If the board believed the dividend policy was correct before a new CEO is appointed there needs to be a strong justification to move away from that policy.
2 – “The board is targeting a yield of X%” – Companies cannot control their share price, only their dividends. Setting a yield target is essentially letting the stock market determine the dividend payment. This reasoning is closely related to, but not quite as concerning as;
My favourite poor excuse –
1 – “The market is pricing in a dividend cut”. This is the ultimate case of the tail wagging the dog. With this innocent sounding phrase, the company’s board has let the stock market decide the capital requirements of their business. This phrase is often accompanied by a comment such as “The dividend yield is above, say 7%, so the market doesn’t believe the dividend can be sustained, therefore there is no harm cutting the payout”. I have heard this many times from stock brokers trying to predict a dividend cut but it really makes no sense. Investors may indeed believe the dividend is unsustainable, and they may be correct, but it should be the underlying cash flows and balance sheet of the business that always determine the appropriate dividend policy.