The S&P Yield has generally decreased over time, as shown in the provided graph spanning from 1871 to 2021.
Payout Ratio
The dividend payout ratio is the portion of earnings that are paid out to investors in the form of dividends.
Dividend \, Payout \, Ratio = \frac{Dividends}{Earnings}
The total payout ratio is the total portion of earnings paid out to equity holders (dividends plus repurchases).
Total \, Payout \, Ratio = \frac{Dividends + Repurchases}{Earnings}
The rest of the firm’s earnings are “plowed back” into the firm to invest in new projects, a.k.a. Retention ratio.
Plowback \, Ratio = 1 - Total \, Payout \, Ratio
What kind of companies have a high retention ratio?
Dividend Payout Ratio: January 2022
Graphical representation of dividend payout ratios for dividend-paying firms as of January 2022. The data includes the percentage of companies falling into various payout ratio ranges (0-10%, 10-20%, etc.) for both the U.S. and globally.
Table of Dividend Payout Ratios by Sub-Region (January 2022):
Lists various regions with their respective dividends, net income, and payout ratios.
Examples include Africa and the Middle East, Australia & NZ, Canada, China, Eastern Europe & Russia, EU & Environs, India, Japan, Latin America & Caribbean, Small Asia, UK, United States, and Global figures.
Types of Dividends
Any payments made by the corporation to its shareholders are considered dividends.
Cash dividends are payments in the form of cash.
Firm’s cash and retained earnings decrease.
Stock dividends are paid out in shares.
e.g., With 3% stock dividends, shareholders get 3 extra shares for every 100 they own.
Not really dividends because no cash leaves the firm.
The number of shares outstanding increases, but the value of each share falls (no change overall).
Example: A firm’s shares are currently trading at $30. What would happen to the share price if the firm declares a 3% stock dividend?
Stock repurchase
Cash Dividends
Ex-dividend date: Only those shareholders who purchased the stock before the ex-dividend date are eligible to receive dividends.
The seller receives dividends if the transaction occurs on or after the ex-dividend date.
Ex-dividend price vs. cum-dividend price:
If the cum-dividend price of a stock is $30, and if the company declared a dividend of $2/share, then what should the ex-dividend price of the stock be?
(Ignore taxes & transaction costs)
Important Dividend Dates
Board of Directors announces a dividend (dividends become a liability once declared).
Owners of the stock on the ex-dividend date will receive the dividend, but any investor that purchases the stock on or after the ex-dividend date will not receive the dividend (two business days before the Date of Record).
Shareholders of record (which are the shareholders on the ex-dividend date) will receive the dividend.
The dividend is paid to all shareholders of record.
When do you expect to see price reaction--if any?
Cash… the Fruit of Microsoft’s Success
In 2004, Microsoft set a record for the most cash ever held by a corporation.
The company had nearly $40 billion in cash, with another $1 billion in cash inflow per month.
What could $40 billion have purchased in 2004?
eBay ($14 billion market cap in 2004), Yahoo! ($10 billion), and Amazon ($6.5 billion), with $10 billion to spare.
The entire airline industry… twice.
23 space shuttles.
Every professional baseball, football, basketball, and hockey team in the US.
Microsoft Special Dividend
On July 20, 2004, Microsoft announced a special dividend of $3 per share.
The dividend would have a date of record of November 17, 2004, and would be paid on December 2, 2004.
With Microsoft’s 10 billion outstanding shares, the total payout was about $32 billion in cash.
The Market’s Reaction
Microsoft’s stock closed at $28.32 on July 20.
The announcement came after trading hours on July 20.
On July 21, Microsoft’s stock opened trading at $29.89, a $1.67, or 5.5%, increase from the previous day’s close.
Why did the market react favorably to the dividend announcement?
Time value of money of the cash?
Investment policy concerns?
The Ex-Dividend Date
The date of record was November 17, 2004.
The ex-dividend date was two business days before, on November 15, 2004.
What happened that day?
Anybody that bought the stock on or after November 15 was buying the stock without the dividend (ex-dividend).
Microsoft’s stock closed at $29.97 on November 12 and opened at $27.34 on November 15… a decrease in price of $2.63.
Ex Dividend Date Price Behavior
In a friction-free world, $3 is the ex-dividend price drop.
In Microsoft’s case, the price dropped by $2.63
Microsoft since the Special Dividend
What has Microsoft done since the special dividend?
The company currently has cash reserves of about $83.03B billion.
Dividend policy:
“The board will continue to evaluate whether to pay a dividend on a quarterly basis and will base its decisions on the Company’s potential future long-term capital requirements relating to research and development, investments and acquisitions, dilution management, and legal and business risks faced by the company.”
Currently, the company pays out a quarterly dividend of $0.28 per share – About $2 billion total paid out for each quarterly dividend.
The company heavily uses stock repurchases
$40 billion in repurchased stock last fiscal year
Outstanding shares: 8.30B billion in that fiscal year
Does dividend policy affect firm value?
Investors’ preferences for dividend versus capital gains
The dividend irrelevance theory
The “bird-in-the-hand” theory
The tax preference theory
The clientele effect
Agency problems
M&M Dividend Irrelevance Theory
Modigliani and Miller: In a perfect market, dividend policy is irrelevant to the equity value.
The firm’s value depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings.
Assumptions to build a perfect market:
No taxes or transaction costs
No default risk
No agency problems
No asymmetric information
The investment policy of the firm is fixed and is not altered by changes in the dividend policy
Dividend Irrelevance Example
Genron Corporation has $20M in excess cash and no debt. The firm expects to generate additional free cash flows of $48m per year in subsequent years. If Genron’s unlevered cost of capital is 12%, then the enterprise value of its ongoing operations is:
Enterprise Value = PV (Future FCF) = \frac{48}{0.12} = $400M
Including the cash, Genron’s total asset value is $420M.
Genron’s board is meeting to decide how to pay out its $20M excess cash to shareholders and is evaluating the following options:
Using the $20M to pay a $2 cash dividend to its 10M shareholders.
Repurchasing shares instead of paying a dividend.
Pay a larger dividend today, in anticipation of high future FCFs.
Dividend Irrelevance Example -Solution
Alternative 1:
P_{cum} = Current Div + PV(Future Dividends) = 2 + \frac{4.8}{0.12} = $42
In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend.
Alternative 2:
Genron can repurchase \frac{$20M}{$42} per share = 0.476M shares, leaving 10 - 0.476 = 9.524M shares.
Genron expects to have $48M in free cash flow, which can be used to pay a dividend of \frac{$48M}{9.524M} shares = $5.04 per share each year. Thus Genron’s share price today is
P_{rep} = \frac{5.04}{0.12} = $42
In a perfect capital market, an open market purchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead.
Dividend Irrelevance Example -Solution
Alternative 3:
Suppose Genron starts to pay $48M in dividends starting this year. It has only $20M in cash today, so needs an additional $28M to pay the larger dividend now. Suppose it raises money by going for an equity issue. Given a share price of $42, Genron could raise $28M by selling \frac{$28M}{$42} per share = 0.67M shares. The amount of dividend per share each year will be
\frac{48M}{10.67M} = $4.5
Under this new policy, Genron’s cum-dividend share price is
Where does the cash come from? All of the other cash is being used for investments.
Answer: issuing new shares of stock.
But, the total value of the company didn’t change, we just transferred some ownership from the old shareholders to the new shareholders.
The capital loss on the stock for the old shareholders exactly offsets the dividend they receive.
Dividend Irrelevance ----MM Continued
So, the old shareholders have the same total value after the dividend as before
Some of the value is in cash from the dividend
The rest of the value is in stock
Alternatively, shareholders could go into the market and sell some stock for cash, producing the exact same results as the dividend (Homemade Dividends).
Investors won’t pay more for the firm to do something they can do cheaply on their own… the firm value is the same with or without dividends.
End result: dividends are unnecessary and irrelevant.
M&M Argument Illustrated
Illustration of dividend irrelevance showing the flow of value between old stockholders, new stockholders, and the firm before and after a dividend payment and new stock issuance.
Example of 1/3rd of worth paid as dividend and raising money via new shares
Dividend Policy with “Imperfections”
We have seen that in a perfect MM world, dividend policy is irrelevant.
However, we know that, in real life, dividend policy is indeed relevant…
Firms that pay dividends seem to do so consistently, and do not like to cut dividends.
A cut or hike in dividends seems to impact price.
So, what market “imperfections” make dividends relevant, and why?
Does payout policy matter when the market is not perfect?
Uncertainty of cash flows
Bird-in-the-hand theory
Taxes
Tax preference theory: taxes on dividends versus capital gains
Clientele effect: taxes on individuals with different tax brackets
What should a firm do?
Agency problems
Asymmetric information
Stability of distribution
Bird-in-the-hand theory: Dividends are “good”
Investors are less certain of receiving capital gains than they are of receiving dividend payments.
They value a dollar of expected dividends more highly than a dollar of expected capital gains because dividends are less risky.
Therefore cost of equity decreases as the dividend payout ratio increases.
Tax preference theory: Dividends are “Bad”
Before 2003, individual investors paid ordinary income taxes on dividends but lower rates on long-term capital gains.
The Jobs and Growth Act of 2003 changed this to the same.
Investors may still prefer capital gains instead of dividends
Time value effects: capital gains are never taxed sooner than dividends
Holding effects: If a stock is held by someone until he or she dies, no capital gains tax is due at all to the beneficiaries
Because of tax advantages, investors may be willing to pay more for low-payout companies everything else the same.
Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971–
Investors may still prefer capital gains. Time value effects: Capital gains are never taxed sooner than dividends. Holding effects: If a stock is held by someone until he or she dies, no capital gains tax is due at all to the beneficiaries.
Tax advantages drive investors willing to pay more for low-payout companies, everything else being the same.
Under “Tax Preference” theory, capital gains are preferred (not dividends).
The Jobs and Growth Act
The Worst Cases of Dividend Payments
The worst possible case for dividends occurs if a company has to issue new stock to fund the dividend
Then, not only is value destroyed because of the taxes on the dividend, but there are the costs of issuing new equity
Underwriter spread
Administrative costs
These firms should cut their dividends rather than incur these costs.
Does that actually happen?
Never raise money to pay dividends. Issuing cost (transaction costs).
Instead of a dividend, should look for other ways to return value to investors.
Payout Preferences
Graphical representation of how stock price and cost of equity are affected by payout under MM Irrelevance, Bird-in-the-Hand, and Tax Preference theories.
Clientele effect
Different groups, or clienteles, of stockholders prefer different dividend payout policies.
Some prefer cash income so they prefer dividend-paying firms
Pension funds pay no taxes
Corporate investors can exclude 70% of their dividend income from taxes, while all capital gains are taxed
Individual investors in low tax brackets
Individuals with high tax brackets are likely to prefer companies with either no or low dividend payouts
Agency Problem
Reduction in agency costs
By reducing excess FCFs, dividends mitigate the agency problem between managers and shareholders
Asymmetric Information
Signaling of financial strength
Assume that managers know more about the quality of the firm’s future earnings than outside investors (“asymmetric information”)
i.e., investors cannot distinguish between “good” and “bad” firms
Managers of a “good” firm can signal their quality to investors by committing to pay high dividends
“Bad” quality firms don’t have the financial muscle to mimic this strategy
Information-content effect of dividends:
Stock price rises when dividends are increased
Stock price drops when dividends are cut
Dividend payment now…
7 Stocks Increasing Dividends In March 2012
List of companies such as JPMorgan Chase (JPM), U.S. Bancorp (USB), State Street (STT), Air Products & Chemicals (APD), Cliffs Natural Resources (CLF), Xilinx (XLNX), and Realty Income (O) that increased dividends in March 2012.
Dividend payment now…
On April 13, 2012, P&G declared a 7% dividend increase (52.5 cents to 56.2 cents).
P&G, which is in the process of cutting 5,700 jobs as it aims to trim $10 billion in costs, has now raised its dividend for 56 consecutive years.
"Sticky" Dividends
Graphical representation of dividend changes at US companies, showing the percentage of companies that increased, decreased, or made no change to their dividends.
In 2020, a crisis year
Of the S&P 500 companies, 287 companies increased their dividends and 11 companies initiated dividends.
Of the S&P 500 companies, 27 decreased dividends and 42 suspended dividends.
While the 42 dividend suspensions were the most in the last 20 years, the number of companies that increased dividends (298) vastly exceeded the number that cut or suspended dividends(69).
In perhaps the most revealing statistic of all, 133 of the 500 largest market cap companies did not pay dividends leading into 2020 or in 2020.
Story so far…
In a perfect MM world without taxes and transaction costs, dividend policy is irrelevant.
In a world with taxes:
A firm (that does not have sufficient cash) should not issue stock/bonds to pay dividends.
Firms that have excess cash have a choice between paying dividends and alternative uses.
Whether the firm should pay dividends or not depends on: returns from alternative uses, personal and corporate tax rates.
Stock Dividends: Example
Imagine a corporation currently has 10 million shares outstanding selling at $60 per share and declares a three-for-two stock split. After the split, what will be the new share price?
After the split, how many shares will be outstanding?
More Types of Dividends
Spin-Offs
Companies sometimes spin off subsidiaries or divisions.
A new company is created, and its shares begin trading.
The parent company gives shares in the new company to the investors as a dividend.
Then investors in the parent company own two different companies.
Examples: 3Com and Palm, Kraft and Altria Group, Travelers, and Citigroup.
DRIPs (Dividend Reinvestment Plans) have become more popular in recent times in US.
Companies allow shareholders to purchase new stock with their dividend proceeds with no commission, sometimes even get to purchase stock at a discount.
Programs are helpful for small investors who don’t need cash income.
Getting $30 in dividends in a quarter doesn’t help much, especially if you have to pay an $8 commission to reinvest the money or go through the hassle of withdrawing it from your brokerage account.
Repurchase of Stock
Stock repurchase is an alternative method of paying out surplus cash to shareholders.
Instead of paying dividends to shareholders, a firm uses surplus cash to buy back shares.
Balance-sheet Impact: After a share repurchase, both cash and the book value of equity decrease.
In a perfect MM world, stock repurchase is as good as cash dividends.
Even though EPS increases post-repurchase, total value to shareholders is the same (see example on next slide).
Example: Dividends vs. Repurchase
(Assume a perfect MM world) A firm has 100,000 shares outstanding. It has excess cash of $300,000 that it can use to either pay dividends or to repurchase shares. The firm’s net income is $450,000, and the (ex-dividend) PE-ratio applicable to the firm is 6.
Suppose the firm pays dividends. Compute the EPS, ex-dividend stock price, and the cum-dividend stock price?
Suppose the firm repurchases shares at $30/share. Compute the EPS and stock price?
Answer Key to Example
Under the dividend option:
Dividend per share = \frac{$300,000}{100,000} = $3
EPS = \frac{$450,000}{100,000} = $4.50
Ex-dividend share price = $4.50*PE ratio = $27
So cum-dividend share price = $27 + $3 = $30
Under the repurchase option:
No. of shares repurchased = \frac{$300,000}{$30} = 10,000
Shares outstanding after repurchase = 90,000
EPS = \frac{$450,000}{90,000} = $5
So stock price = $5*PE ratio = $30
Dividends and Stock Repurchases in the US
Graphical representation of dividends and buybacks on the S&P 500 from 1988-2021, showing the magnitude of buybacks compared to dividends over time. It also includes the proportion of total payout from buybacks.
Advantages of Share Repurchase
No long-term commitment involved
Regular dividends imply a commitment to continue payments in the future (negative consequences to cutting dividends)
Tax advantage
When capital gains are taxed at a lower rate than dividends
Moreover, shareholders have the option of not selling shares (i.e., they can avoid realizing capital gains)
Maintaining control (with “targeted” repurchases)
Provides a way for insiders to increase control and thwart hostile takeover attempts
Less costly mechanism to alter debt-equity ratio
Firms pay significant transaction costs when they issue stock/debt
Summary: A sensible dividend policy
We have seen that:
Firms should avoid having to cut back on positive NPV projects to pay dividends
Firms should avoid issuing stock to pay dividends in a world with personal taxes
Repurchases should be considered when there is a surplus of unneeded cash
Overall:
Firms with many positive NPV projects relative to available cash should have a low dividend payout
Firms with few positive NPV projects relative to available cash should have a high dividend payout