Saturday, September 15, 2012

Should More Companies Adopt Flexible Dividend Policies?

In the U.S. and U.K. markets, the most common form of dividend policy is one that aims to pay at least the same amount year after year, regardless of the company's performance that year. I'll call this the "consistent" dividend policy.

In such a system, a dividend increase is typically seen as a positive thing -- a sign that the company expects profitability to improve in coming years. Conversely, a dividend cut is usually a negative -- a sign that the company has run into trouble and needs to shore up cash.

Indeed, a number of companies have run into trouble desperately trying to maintain the historical dividend level -- borrowing, selling assets, etc. -- when the logical thing to do would have been to reduce the dividend payout until things got better.

An alternative approach is the "flexible" payout policy in which a company establishes that it will pay a certain percentage of earnings or free cash flow each year. The payout amount could fluctuate up and down, but it relieves the company of having to worry about maintaining a certain payout each year.

I see benefits and drawbacks to both approaches. In the end, I think it depends on the nature of the company's business and the precedent that it has set with shareholders.

U.K.-based Rotork, for example, operates in a cyclical industry and smartly implements a flexible dividend policy that incorporates a "core" dividend that grows in line with earnings plus an "additional" dividend in particularly good years. If the company runs into a bad year, the total payout may be lower than the previous year, but shareholders will likely be more accepting of that since the policy has been clearly communicated and consistent.

On the other hand, Procter & Gamble (a stock I own) operates in a more defensive industry and has paid an increasing dividend for 56 years. As such, its shareholders expect a consistent (and rising!) payout each year. A lower dividend would be disastrous signal.

All that said, many large companies with consistent dividend policies also practice flexible distribution policies -- it's just that they substitute buybacks for cash dividends to bridge the gap. In other words, they maintain a consistent dividend policy and adjust to the business climate using buybacks.

As the chart below shows, since 1999 the modified payout (dividends + buybacks) has fluctuated quite a bit, but the median modified payout has been about 82%.

Source: Standard & Poors
U.S. companies are paying out most of their earnings over the business cycle, just not with dividends -- the median dividend payout ratio over the period is 35% with the balance going to buybacks.

If anything, then, investors who prefer a flexible dividend policy should be demanding that companies use a greater percentage of actual dividends in their distribution policies (i.e. a normal + special dividend policy). I think there's a good case for that.

What's your take? Have a suggestion for future posts? Please post your comments below.

Have a great weekend.


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