Companies should invest in growth if doing so will generate a return above the cost of capital, as this will increase stockholder value. If there are no value-enhancing investments, surplus cash should be returned to stockholders.
Stockholder expectations will drive dividend policy, and changes to that policy should be signaled clearly to investors.
Stockholders gain value from their investments in two ways—either by receiving dividends or by realizing a capital gain. Dividend policy is determined directly by a company’s board, which has to decide whether to make a payout or to reinvest.
Although many factors underlie the dividend decision, there is one basic rule: If there are investment opportunities where the expected return exceeds the company’s cost of capital, value will be created by making the investment and it should be done. If there are insufficient value-creating opportunities, the surplus cash should be distributed to stockholders.
Therefore, the question to ask when considering reinvestment versus distribution to investors should be: Will this create stockholder value?
Companies that pay dividends try to increase the absolute level of dividend each year in order to meet investor expectations.
Two numbers are relevant to understanding dividend policy: The level of the annual dividend (which may in practice be paid in quarterly or semi-annual installments), and the dividend payout ratio (the dividend for the year as a percentage of after-tax income). Stockholders are concerned with the absolute level of dividend they receive, but will also have an eye on the dividend payout ratio.
If the payout ratio is kept constant, then, as profits grow, the absolute level of dividend will become progressively larger. However, volatility in profits would mean volatility in payouts, and this is unsatisfactory to investors. Accordingly, most companies have a more flexible attitude to the payout ratio, aiming to smooth the distribution, increasing dividends annually but not exactly in line with the change in profits.1 This is particularly relevant in cyclical industries, where a progressive dividend implies a changing payout ratio over the cycle.
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