How Companies Decide Their Dividend Payout Policy

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Of the many decisions a company's board of directors has to make, one of the most important involves determining the company's dividend payout policy. The justification for a company having any value at all is overwhelmingly tied to its ability to pay dividends either now or at some point in the future. A policy as to when and how much cash the company returns to its owners in the form of dividends has an enormous influence on the types of investors who are attracted to ownership as well as on the total return of an owner's investment.

Board Considerations for Dividend Payout Policy

Here are some factors a board will consider when determining its payout policy for dividends:

Opportunities to Reinvest Surplus Free Cash Flow

A company in the process of expanding probably will not pay out a dividend if it can create more value by putting that capital to work through reinvestment. Many companies, such as Microsoft, wait decades before issuing their first dividend, as they invest their earnings back into their asset base to expand at high returns on capital. Certain companies that are likely not to expand, such as those that are asset-intensive with low returns on capital, may issue dividends to increase liquidation for their businesses.

Stability of Balance Sheet and Income Statement

Responsible companies need to have adequate cash reserves to absorb periods of economic stress. Some types of businesses have wildly volatile revenues or earnings that require greater management than others, and it can be dangerous for these businesses to push a high dividend payout on an accelerated basis.

How Other Companies in the Sector Pay Out

Companies do not operate in a vacuum. They may have a difficult time raising capital or attracting investors if they have the same economics as their peer companies but offer a much lower dividend yield.

Type of Investors Sought

Companies that pay strong dividends on a regular basis tend to appeal to wealthier, more stable investors. Certain investors may also be attracted to dividend issuers because they can provide an effective floor on stock, everything else being equal, due to yield support.

Major Stockholder Needs

Companies are likely to keep their major stockholders and relevant tax laws in mind when issuing dividends. For example, an enormous portion of Hershey's common stock is owned by The Hershey Trust, which manages the endowment created by Milton Hershey and his wife to provide for a private boarding school for children from low-income families. A particular quirk of Pennsylvania law makes it all but impossible for the trust to sell a meaningful amount of stock. In turn, Hershey has paid out dividends, as its major shareholder depends on that income to put thousands of children through school.

That said, some boards may decide on arbitrary figures for dividend payouts (even as much as 25% of earnings) based on irrational philosophies that have little bearing on the most sensible economic course of action. This appears to happen more than an investor might expect.

Comparative View: United Kingdom

Companies in the United States and the United Kingdom have adopted differing philosophies toward dividend payout policies. In the United Kingdom, many companies treat payouts on a year-by-year basis, and they look at current earnings and economic forecasts the same way a private business might. This approach creates volatility in the dividend rates, meaning an investor may get more one year and less the next, even if the business does well and increases its dividend on a net basis over time.

Companies in the United States have stayed away from this approach. Investors expect and demand companies to smooth dividend increases so that dividend cuts are relatively rare. As a result, companies do not push dividend payouts as high as they can during boom years and instead may build reserves and gently increase dividends per share at a slower rate to keep up their sterling record of rising payouts. Companies in the United States are celebrated if they are able to raise their dividends each year without fail for 25 years or more; these companies are referred to as "Dividend Aristocrats."