VideoSee the CFO Free Cash Flow Scorecard
Recent trends in corporate cash flow suggest that U.S. companies are continuing to clean up their financial acts. In fact, they are increasingly in a position to initiate or increase dividend payments, even if they also begin to reinvest in their business or make big acquisitions.
These conclusions are drawn from a study of cash flow by the Financial Analysis Lab of the College of Management at the Georgia Institute of Technology. After adjustments for one-time and nonoperating items, the study found that cash flow from operations at the 86 nonfinancial companies that make up the S&P 100 grew 21 percent between 2000 and 2003. Meanwhile, their adjusted free cash flow — adjusted operating cash flow minus capital expenditures and preferred dividends — advanced by a robust 58 percent.
What's more, the big increase in adjusted free cash was not primarily the result of reduced capital spending, as this was cut collectively by less than half the gain, or roughly 20 percent. Nor was the elimination of preferred dividends from the free-cash calculation largely responsible, according to Charles W. Mulford, an accounting professor at Georgia Tech who directs the lab. Mulford says the study — presented here as the CFO Free Cash Flow Scorecard — shows that preferred dividends were a negligible factor, amounting to a "rounding error."
Instead, companies have improved their cash flow mostly by reducing overhead, shedding less profitable assets, and boosting operating cash flow. That means these companies are now on such a financially firm footing that they can, if they wish, put more money into dividend payments without sacrificing their ability to grow.
And in fact, that's what an increasing number of companies are doing. According to Standard & Poor's, more than half of the companies that make up the S&P 500 index expect to raise their cash dividend payout next year. That would continue the reversal of a decades-long trend away from dividends. Last year, there were 252 dividend increases by the S&P 500, and only 229 in 2003.
The scorecard suggests that this trend is sustainable, at least among the largest companies. While dividends paid by the 86 companies in the scorecard rose 12 percent from 2000 to 2003, from a collective $65 billion to $73 billion, their adjusted free cash flow has been growing even more dramatically. As a result, the proportion of adjusted free cash represented by those dividend payouts fell from 40 percent to 28 percent.
A New Perspective
What accounts for the increase in dividend payers? A number of plausible reasons have been advanced, such as the 2003 legislation that aligned dividend tax rates with capital-gains rates (15 percent), making dividends as attractive to shareholders as stock repurchases.
As Mulford sees it, the trend to higher dividend payouts reflects a fundamental change in perspective on the part of U.S. companies. "We saw an extended period, probably dating back through the long-term bull market that started in the early 1980s, during which companies gradually retained more of their earnings, lowering dividend payouts. Cash that was returned to shareholders was typically done so with stock buybacks, given the preferred tax treatment," he notes. "I think firms have found that they've reduced payouts about as far as they can, and there is a greater sense now that shareholders want increased dividend payouts."
If so, institutional investors in particular may be driving the demand, according to a recent survey of 384 financial executives by researchers from Duke University and Cornell University. The executives expressed two primary reasons for initiating a dividend: "a sustainable increase in earnings, and demand by institutional investors." Tax considerations, meanwhile, were secondary, according to a follow-up survey (see "Payout Policy in the 21st Century" by Alon Brav et al., at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=571046).
It's not surprising that the sustainability of payouts is a critical issue. But the Georgia Tech study, which was co-authored by Michael L. Ely, a financial analyst at the lab, with the help of research assistants Mario Martins and Amit Patel, suggests that most of the payouts by the S&P 100 can be sustained as long as recent cash-flow trends continue. "Companies with strong free cash flow are able to reinvest, have cash for acquisitions, and still pay dividends," notes Mulford.
Another issue is to what degree the trend to higher dividends reflects a dearth of opportunities to reinvest profits. After all, dividend payments come in lieu of retained earnings, and thus represent an acknowledgement on management's part that it can find no better use for the money. But fewer than half of the CFOs in the Duke/Cornell survey said that "the availability of good investment opportunities is an important or very important factor affecting dividend decisions."
Reader Comments» Post a comment