Deliberating on dividend policy.

• Author: ESCHERICH, FREDERIC A.
• Position: Statistical Data Included

Dividend policy's most important uses are to: (1) return excess cash to shareholders; (2) effectively manage the company's cash needs and capital structure; and (3) credibly signal shareholders about future earnings prospects. The recommendations herein should be viewed as a starting point.

FOR THE VAST MAJORITY of larger public companies, dividend policy is an important component of maximizing shareholder value. While dividends have always been an important part of shareholder returns, dividend yields have historically been much higher than they are today. Since peaking in 1979-80 at a yield of 5.7%, dividend yields have gradually drifted lower: in 1990, the dividend yield of the S&P 500 was 3.4%; in 1995, 2.9%; and in 1999, 1.4%. Furthermore, with the rapid rise in stock prices, in recent years, dividends have comprised a much smaller portion of total shareholder returns than they have historically. For example, over the past five years, yield has represented 8% of the return on the S&P 500 versus 34% for the 1926 to 1999 period. While current high stock market prices have somewhat reduced its importance, dividend yield is likely to grow again in prominence when share price appreciation returns to more normal levels, or if stock prices retreat.

While it's difficult to generalize about dividend policy because it is usually very company-specific or industry-specific, some general observations are possible. While current earnings and expected earnings growth drive a company's stock price, effective dividend policy can influence its trading multiple within a range. Dividend policy's most important uses are to: (1) return excess cash to shareholders; (2) effectively manage the company's cash needs and capital structure; and (3) credibly signal shareholders about future earnings prospects. The recommendations herein should be viewed as a starting point.

Policy recommendations

It is our view that dividends are the primary vehicle for returning cash to shareholders. A company should choose a payout ratio that directs the majority of its free cash flow to shareholders as a dividend. In doing this, a company should avoid a dividend payout that is too high, in part because a high payout ratio reduces its financial flexibility and increases the risk of a ratings downgrade and/or dividend reduction. Cuts in the dividend also should be avoided. Dividend increases should signal confidence in the future; this is especially important in times of earnings weakness, and less important during periods of strong earnings. If a company can afford a dividend, in most cases a nominal one should be paid, expanding the stock's appeal to the broadest possible group of shareholders. Irregular special dividends and stock dividends should be avoided.

Dividend policy should be viewed as part of an integrated financial plan. Other than for firms that trade primarily on yield, a company's stock price largely reflects its current earnings and future earnings growth rate, not its dividend policy. Shareholder value is maximized through an effective investment strategy, financed by an optimal capital structure. As shown in the accompanying exhibit, we view both dividend payments and share repurchases as a byproduct of these strategies and therefore an important, yet residual, decision.

Use the dividend as the primary vehicle to distribute cash to shareholders. Once a company's operating plan has been appropriately financed, dividends should be the primary source of cash flow paid out to shareholders. As a payment that shareholders can largely depend on receiving, dividends add stability and bond-like qualities to a company s stock price. This is generally positive, as it somewhat lessens stock price volatility, and can slightly lower a firm's cost of equity.

Another important consideration is that companies in the same industry often will generate similar levels of excess cash flow, causing them to grayitate to similar dividend payouts. As portfolio managers select among this group of potential investments, it is important that a company is not viewed as paying out a substandard dividend or viewed as "holding back" from committing to regular cash payments to shareholders.

Use the dividend to appropriately signal shareholders about future prospects. Dividends play an important role in signaling shareholders about management's confidence...