The Power of Paying Dividends

It’s not for every company, but many CFOs like the financial discipline of regular payouts to shareholders.
Vincent RyanMarch 7, 2012

Successful regular dividend policies require commitment. Unlike a share-buyback program, where a board of directors sets an authorization level but the company doesn’t have to purchase the total amount, common dividends require a company to pay what it said it would — and, barring catastrophe, fork over at least the same amount per share next quarter.

“Once a company starts paying a cash dividend, it’s a precedent,” says David Chichester, a partner at Tatum and former CFO of Starbucks Coffee Japan. And declaring a dividend can put a company on the “treadmill” of wanting to increase the dividend year after year. “Once you start, it’s painful to stop,” he says.

But dividends have plenty of upside. They may be more flexible than CFOs think. Many companies have bought into the upsides over the past two years, as corporate profits have rebounded and cash on balance sheets expanded. In the first month and a half of 2012, close to 60 companies increased or declared a dividend, according to Standard & Poor’s. If a company can pay enough of a dividend to give an investor a 2% to 4% yield, with potential appreciation of the dividend besides, that’s attractive in an extremely low-rate interest environment.

Duff & Phelps, a financial advisory and investment banking firm, has paid a dividend since 2009 and increased it the past two years. “We believe a dividend attracts a broader base of shareholders,” says Patrick Puzzuoli, the firm’s finance chief. “Certain individuals wouldn’t even look at investing in companies that don’t offer a dividend.”

Before jumping into paying a regular dividend, though, management has to determine whether it fits the company’s financial strategy.

“The first thing a company needs is a strategy for the financial structure of the company,” says Al Ehrbar, an executive vice president at EVA Dimensions, a provider of tools and training for analyzing corporate performance. “How much debt does it want in its capital structure? What kind of cash balance does it need? How much unused debt capacity should it maintain for future expansion or acquisition opportunities?”

At ABM Industries, a provider of facilities-management services, a dividend is part and parcel of its thinking about value creation. The company has paid a cash dividend for 184 straight quarters, going back to the late 1960s. “We really believe in sustained, long-term value,” says CFO James Lusk. “The combination of increasing dividends over time and a long-term view creates really good value for shareholders. We’re not the kind of stock that is going to pop 30% in a quarter.”

When a company is a consistent, long-term dividend payer, however, it has to spend the rest of its cash very wisely, says Lusk. When ABM acquires companies, which it does frequently, it looks for them to be accretive in the first quarter, for example. “We’ve had value investors say to us, ‘We like the idea that you pay dividends because you are that much more judicious with the rest of your money.’”

Yet freeing up even more cash to buy companies instead of paying a dividend wouldn’t suit ABM. “The argument against a dividend, of course, is that [the company] could take the money and invest in even more acquisitions, but our policy is consistent with our risk tolerance and the amount of debt we have,” adds Lusk.

Duff & Phelps views dividends “as a means to creating some fiscal responsibility and financial discipline,” says Puzzuoli. “Every year we have to budget for these dividends and make sure we’re committed to paying them.”

Long-term sustainability of a common dividend is crucial, according to a study published last year by J.P.Morgan’s corporate finance advisory team. Dividend payouts should start at low levels, the team advises, and increases should be gradual. “We believe that investors respond better to a series of consistent increases than to one large increase that leaves no room for growth thereafter,” wrote the advisory team.

Other attributes of a best-in-class dividend policy include capital planning, benchmarking to peers, and “materiality” — making sure dividends and dividend increases are a meaningful part of the total return investors expect. But some dividend-paying companies can go overboard with metrics, rigidly adhering to paying out a percentage of earnings each quarter, for example.

EVA Dimensions’s Ehrbar believes there is more flexibility with dividends than typically thought, and that companies shouldn’t stick to metrics like “payout ratio.” Defined as the amount of earnings paid out in dividends to shareholders, the ratio is calculated by dividing dividends per share by earnings per share. The lower the ratio, common wisdom says, the more secure a stock’s dividend is perceived to be.

“Historically, companies have tried to maintain a certain payout ratio — 30% or 50% of earnings, for example — but those numbers fundamentally make no sense,” Ehrbar says. “If the company is paying out 50% of earnings, then it is saying, ‘We know we are going to have to retain 50% of earnings to fund the business forever.’ But why in some years wouldn’t you retain all your earnings, especially during a recession? And in a really great year maybe you only need to retain 20% of your earnings.”

Ehrbar argues that there is no right percentage of earnings to distribute. “Nothing should be paid out unless it’s money you don’t have a good use for,” he says. “If you can find ways to invest it that will return more than the cost of capital, then you should keep it and invest it.”

Indeed, Ehrbar sees a lot of virtue in special dividends, or one-time shareholder payouts like Microsoft’s $3 per-share dividend in 2004. Sara Lee, Boise, Diamond Offshore Drilling, and NYSE Euronext have all taken the opportunity to pay a special dividend in the past 12 months.

ABM has increased its dividend per share by roughly two cents per year since 2007, and forecasts doing the same for 2012. The result? If ABM stockholders had reinvested their dividends every year from 2001 to 2011, they would have gotten a return of about 6%.

Unlike many companies during the financial crisis and the recession, ABM’s common dividend rose rather than fell, because its earnings were rising also. “We haven’t had a situation where earnings actually go down,” says Lusk. “If they did, with this board and mind set we would probably still very seriously consider a dividend.”

Cutting or eliminating a dividend clearly sends a negative signal to the financial markets, and boards of directors loathe doing it. When GDP is humming along and the unemployment rate is at 4% to 5%, it’s a particularly dangerous time to do so, says Tatum’s Chichester: “In a way, it’s more punitive to cut a dividend then, because other [companies] are doing well.”

In contrast, many companies slashed dividends during the recession. One hundred and thirty-one nonfinancial firms lowered their common dividends in 2009 and did so by an average of 9.1%, according to data from S&P Capital IQ. Now, well into a modest economic recovery, companies are bringing their dividends back, close to prerecession levels. Share prices suffered during the downturn, but have rebounded.

If a dividend cut occurs due to poor macroeconomic conditions, shareholders may be more forgiving. CFOs who worry about unexpected downturns affecting their ability to pay a dividend can take some comfort: dividends are a commitment, but unlike an interest payment on a bond, for instance, turning off the spigot in times of crisis isn’t fatal.