payout policy in the 21 st century

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Payout Policy in the 21Payout Policy in the 21stst Century CenturyAlon Brav

Duke University, Durham, NC USA

John R. GrahamDuke University, Durham, NC USA

Campbell R. HarveyDuke University, Durham, NC USA

National Bureau of Economic Research, Cambridge, MA USA

Roni MichaelyCornell University, Ithaca, NY USA

IDC, Israel

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Brav/Graham/Harvey/Michaely: Payout Policy

Introduction

• In 1956, John Lintner laid the foundation for the modern understanding of dividend policy

• He conducted detailed interviews with 28 companies• His research helped set the agenda for theoretical and empirical

research on dividend policy

• Much has changed in the last 50 years. – Possibly different payout policy goals– Repurchases– More insights from theory that may help direct the spotlight in the right

direction

• We revisit this path-breaking study at the beginning of the 21st century

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Introduction

• We survey 384 financial executives with an instrument that focuses on both dividends and repurchases– 256 public, 128 private

– Most presented results are based on the public firms

• We conduct one-on-one interviews with 23 CFOs or Treasurers of prominent corporations– Interviews last between 40 minutes and two hours

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Methodology

Survey and Interview Design• Draft survey instrument “refereed” by both finance

researchers and experts in survey design• Interviewed structured to adhere to best scientific

practices of interviews, e.g. Sudman and Bradburn (1983)

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Methodology

Survey Delivery• Survey CFOs, Treasurers, Finance VPs• Primarily members of Financial Executives

International• Two $500 random winners• Three surveys

– FEI CFO Forum (April 23, 2002, Co. Springs CO)– Dave Ikenberry NFCF (May 1, 2002, Houston TX)– Mass emailing to 2200 FEI members– Overall ~16% response rate

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Goals of Treasury department:• Fund investment

– M&M

• Liquidity and possible contingencies• Payout decisions are second-order

Except...• DO NOT CUT DIVIDENDS ranks equal to or

above all of these items


How are payout decisions made?

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Brav/Graham/Harvey/Michaely: Payout Policy Payout vs. Investment Decisions

0% 10% 20% 30% 40% 50% 60% 70% 80%

Percent of CFO's who rate choice as +1 or +2 (on scale of -2 to +2)

6j: M&A strategy

7j: M&A strategy

6h: Good alternative investments

7h: Good alternative investments

3a: Investment decision made 1st

4a: Investment decision made 1st

3e: Fund externally, rather than cut

4e: Fund externally, rather than cut

Repurchases Dividends

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Dividends vs. Repurchases (Fig. 2)

0% 10% 20% 30% 40% 50% 60% 70% 80%

Other

Retain as cash

Invest more

Mergers/Acquisitions

Repurchase shares

Pay down debt

Fig. 2A: Of funds that are used to pay dividends, what is their most likely alternative use? (Current dividendpayers only). For each response we report the percentage of respondents who answer 1 or 2 on a scale from -2 to+2.

0% 10% 20% 30% 40% 50% 60% 70% 80%

Other

Pay more dividends

Retain as cash

Invest more

Mergers/Acquisitions

Pay down debt

Fig. 2B: Of funds that are used to repurchase shares, what is their most likely alternative use? (Current sharerepurchasers only). For each response we report the percentage of respondents who answer 1 or 2 on a scalefrom -2 to +2.

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Complements or Substitutes?

• Level of dividend fixed

• Substitute repurchases for change in dividends– One way substitution

• Would use even more repurchases if they were free of constraint of dividend history

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Lintner (1956)

Three main points• Target payout ratio (dividend/earnings)• Dividend policy set conservatively

– “partial adjustment” to target payout– smooth through time– sticky (history important)

• Level given, focus on changes

– tied to long-run sustainable earnings– do not increase now if you might have to cut later

• No repurchases

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Compare to Lintner (1956)

Dividend policy still “conservative”?• Yes• Perceived big penalty for cut, small reward for

increase– So, smooth, to avoid future cuts

• Path dependence of dividend policy• BUT

– stealth dividend cut if possible

– holding dividend constant OK

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Brav/Graham/Harvey/Michaely: Payout Policy Payout Decisions Still Made Conservatively? vs. Lintner (1956)

Repurchases: No, flexible Dividends: Yes, still conservative

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%


5c: smooth from year to year

5j: not want to cut in future

5b: change in div what matters

6L: Maintain historic policy

7L: Maintain historic policy

3d: Neg. consequence to cutting

4d: Neg. consequence to cutting

5d: Try to avoid cutting

6d: Try to avoid cutting

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Brav/Graham/Harvey/Michaely: Payout Policy Conservatively increase payout? Similar to Lintner (1956)?

0% 10% 20% 30% 40% 50% 60% 70% 80%


6a: Temporary increase in earnings

7a: Temporary increase in earnings

6d: Excess cash on balance sheet

7d: Excess cash on balance sheet

6b: Sustainable change in earnings

7b: Sustainable change in earnings

6c: Stability of future earnings

7c: Stability of future earnings

RepurchasesDividends

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Payout ratio still target? vs. Lintner (1956)

0% 10% 20% 30% 40% 50% 60%

Other

Do not target at all

Dividend yield

Growth in dividends per share

Dividend as a % of earnings

Level of dividends per share

For those that paid dividends within the past 3 years, what do you target when you make your dividend decisions?

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0% 10% 20% 30% 40% 50% 60%

A strict goal

Not really a goal

A somewhat strict goal

A flexible goal

For those that paid dividends within the past 3 years, is the target part of a strict goal or a flexible goal?

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Extension of Fama-Babiak (1968), Choe (1990)

• The SOA= and TP= . • Both SOA and TP have declined through time using

both matching sample to our survey and broader Compustat sample

.21,1, uEDD ititiiiti

1̂ 12 ˆ/ˆ

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Summary vs. Lintner (1956)

• Dividend policy still very conservative• Modern cash cows live in (close to) Lintner

world• Repurchase policy is not (i.e., it is more flexible)

• Payout ratio no longer target• Targets very flexible

• Repurchases now very important

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Miller and Modigliani (1961)

• Payout Policy irrelevant if capital markets perfect

• Imperfections that could explain payout policy– Taxes– Managerial agency conflict– Information/signaling – Other factors (EPS, float, credit ratings, etc)

• Clienteles could result from imperfections

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A. Taxes

• Theory: At least for individual investors, dividends are taxed move heavily than capital gains.

• Therefore:– Firms should consider investors’ taxation when

deciding about payout policy – Relative taxation should affect the amount of

dividends they pay

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A. Taxes• Interviews: repurchases are “efficient way to return capital”

– taxes (2nd order) important

• Surveys: modest support

0% 10% 20% 30% 40% 50% 60% 70% 80%


8a: Investor taxes lower vs. dividends

6g: Investor taxes

7g: Investor taxes


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B. Clienteles• Investors that pay (relatively) more taxes on

dividends should hold stocks that pay out through repurchases.– Translation: Individual investors should have

an aversion to dividend paying stocks. By implications, institutions should be more attracted to such stocks.

• Prudent man• Institutions as monitors

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B. Clienteles

• Retail investors– Prefer dividends, in spite of tax disadvantage

– Firms like because loyal

• Institutions– If anything, prefer repurchases

– Some can not invest in zero dividend stocks

• 42% say pay dividends because of prudent man rules

– Tax advantage not an issue to institutions

– Firms like because they “have the money”

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B. Clienteles• Companies do not think that dividends attract institutions more so than do

repurchases• Companies do not use dividends or repurchases attract institutions to

monitor• Inconsistent with Allen, Bernardo, and Welch (2000) idea that firms use

dividends to attract institutional investors

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


6n: Attract retail investors7n: Attract retail investors

6i: Influence of institutions7i: Influence of institutions

6p: Attract inst. bc they monitor7p: Attract inst. bc they monitor

6o: Attract institutions7o: Attract institutions


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C. Agency Stories

• Firms pay dividends to impose discipline on managers

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C: Free Cash Flow

• Interviews: some say: “money can burn hole in pocket”

– But payout not the way to fix the problem

• Surveys: (1) no support in general, (2) repurchases work as well as dividends but (3) Cash cows are much more likely to pay; more reluctant to cut; more likely to keep dividend growth as earnings growth

0% 10% 20% 30% 40% 50% 60% 70% 80%


6f: Disciplinary role

7f: Disciplinary role


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D. Asymmetric Information

• Conveying information

• Costly self-imposed action—Signaling

• Adverse selection – Do informed investors benefit from repurchase programs,

at expense of uninformed?

• Stock undervaluation

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D: Do payout decisions convey information? • Interviews: Yes, punctuation mark at end of sentence

– Need to be consistent with other forms of communication– Repurchases convey as much as dividends

• Surveys: Yes, convey info in general

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


6m: Running low on investments?

7m: Running low on investments?

3b: Convey information?

4b: Convey information?


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Brav/Graham/Harvey/Michaely: Payout Policy Information: Signaling

0% 10% 20% 30% 40% 50% 60% 70% 80%


5g: bear external financing cost

5h: investor bear dividend tax

5i: pass up good investments

3i: Show we can bear costs

4i: Show we can bear costs

3h: Look better than competitors?

4h: Look better than competitors?


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D. Information: Signaling• Surveys

– No supporting evidence – Scores are even lower for growth/risky firms– 39% (16%) say keep div (repurchase) policy of peers

• Interviews– Spent hours on this issue– Generally try to group selves with peers (not separate)– No evidence of

• increasing dividend to show market that firm is strong• viewing dividend as self-imposed cost

– Avoiding dividend cut• Possibly a signal (costly for bad firms, separate from bad)• Cuts are rare – can’t explain dividend policy for most firms• Does not explain why firms pay dividends in the first place

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D. Information: Stock Price• Interviews: Would like to buy when price low, but

– often want to maintain liquidity at this time– do not want credit rating downgrade– So, it’s a conditional objective

• Surveys: repurchases, stock good investment

0% 10% 20% 30% 40% 50% 60% 70% 80%


6q: Stock price low

7q: Stock price low


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E. Other factors: EPS• Interviews: managers are concerned about EPS

– Some think it’s automatic that repurchases increase EPS– Other believe that it depends on alternative use of funds

• Surveys: EPS important

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


8g: Options not dividend protected

8f: Offset stock option dilution

8b: Increase EPS

Repurchase questions

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E. Other factors: Float and credit ratings• Interviews: Float very important

– Execs think they need to have a large number of shareholders

• Interviews: credit rating important– Hoard cash to improve rating– Especially for financial firms or firms with financial divisions


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Initiate with repurchases or dividends?

0% 10% 20% 30% 40% 50% 60% 70%

some combination ofdividends andrepurchases

dividends only

share repurchases only

Fig. 6D: What would your first payout be if you were hypothetically deciding to pay out capital for the first time. (For

neither dividend payers nor share repurchasers only.)

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Brav/Graham/Harvey/Michaely: Payout Policy Why initiate payout?

0% 10% 20% 30% 40% 50% 60% 70% 80%


9L: Offset stock option dilution

9j: Increase EPS

9n: Float/liquidity improves

10c: Extra cash

9c: Extra cash

10L: convey info bc undervalued

9m: convey info bc undervalued

10i: stock undervalued

9i: stock undervalued


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Conclusions

• Payout policy is not first-order important* (M&M)

• Repurchases: decided de novo

• Dividends: level very important

• Managers prefer repurchases over dividends because they are more flexible. – Not because of taxes.

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Conclusions

• According to managers, payout– convey information – NOT being used as a costly signal– NOT being used to attract institutions

• Managers do not use dividends over repurchases to attract institutions

• Institutions do not push for more dividends

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Conclusions

• Managers of cash cows believe more strongly that– Dividends should be stable– Keeping dividend growth rate with earnings

growth

• But all managers reject the notion that they need dividends so that they will not spend cash unwisely.

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Rules of the Game: How payout policies are determined

• Make investment plans first*

• Take care of cash/liquidity needs

• *BUT, remember, level of dividends fixed• Only reduce dividends in extraordinary

circumstances• Severe penalty for cutting dividend because the market

believes that “cuts precede bad news”• So, don’t ever cut dividends

• unless you have an amazing investment opportunity• smaller penalty if competitors cut

• Think very carefully before initiating dividends

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Rules of the Game

• Desire to maintain the level of dividend “at any cost” consistent with findings in Graham, Harvey and Rajgopal, 2004, “The Economic Implications of Corporate Financial Reporting”• Here managers desire to hit consensus EPS “at any cost”• 55% would knowingly sacrifice value (not pursue a very

positive NPV project) if it would cause the firm to miss next quarter’s target!

• 78% would knowingly sacrifice value to smooth earnings

payout policy in the 21 st century

Documents

payout policy payout

payout policy lintner

payout policy dividends

payout policy introduction

payout policy complements

dividend policymuch

survey designinterviewed

grahamduke university