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dividend payments. For example, companies are not allowed to pay a dividend out of legal capital, which is generally defined as the par value of outstanding shares.1

Dividends Come in Different Forms

Most companies pay a regular cash dividend each quarter,2 but occasionally this regular dividend is supplemented by a one-off extra or special dividend.3

Dividends are not always in the form of cash. Frequently companies also declare stock dividends. For example, Archer Daniels Midland has paid a yearly stock dividend of 5 percent for over 20 years. That means it sends each shareholder 5 extra shares for every 100 shares currently owned. You can see that a stock dividend is very much like a stock split. (For example, Archer Daniels Midland could have skipped one year’s stock dividend and split each 100 shares into 105.) Both stock dividends and splits increase the number of shares, but the company’s assets, profits, and total value are unaffected. So both reduce value per share. The distinction between the two is technical. A stock dividend is shown in the accounts as a transfer from retained earnings to equity capital, whereas a split is shown as a reduction in the par value of each share.

Many companies have automatic dividend reinvestment plans (DRIPs). Often the new shares are issued at a 5 percent discount from the market price; the firm offers this sweetener because it saves the underwriting costs of a regular share issue.4 Sometimes 10 percent or more of total dividends will be reinvested under such plans.

Dividend Payers and Nonpayers

Fama and French, who have studied dividend payments in the United States, found that only about a fifth of public companies pay a dividend.5 Some of the remainder paid dividends in the past but then fell on hard times and were forced to conserve cash. The other non-dividend-payers are mostly growth companies. They include such household names as Microsoft, Cisco, and Sun Microsystems, as well as many small, rapidly growing firms that have not yet reached full profitability. Of course, investors hope that these firms will eventually become profitable and that, when their rate of new investment slows down, they will be able to pay a dividend.

1Where there is no par value, legal capital is defined as part or all of the receipts from the issue of shares. Companies with wasting assets, such as mining companies, are sometimes permitted to pay out legal capital.

2In 1999 Disney changed to paying dividends once a year rather than quarterly. Disney has an unusually large number of investors with only a handful of shares. By making an annual payment, Disney reduced the substantial cost of mailing dividend checks to these investors.

3Special dividends are much less common than they used to be. The reasons are analyzed in H. DeAngelo, L. DeAngelo, and D. Skinner, “Special Dividends and the Evolution of Dividend Signaling,” Journal of Financial Economies 57 (2000), pp. 309–354.

4Sometimes companies not only allow shareholders to reinvest dividends but also allow them to buy additional shares at a discount. In some cases substantial amounts of money have been invested. For example, AT&T has raised over $400 million a year through DRIPs. For an amusing and true rags-to- riches story, see M. S. Scholes and M. A. Wolfson, “Decentralized Investment Banking: The Case of Dividend-Reinvestment and Stock-Purchase Plans,” Journal of Financial Economics 24 (September 1989), pp. 7–36.

5E. F. Fama and K. R. French, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” Journal of Financial Economics 60 (2001), pp. 3–43.

Fama and French also found that the proportion of dividend payers has declined sharply from a peak of 67 percent in 1978. One reason for this is that a large number of small growth companies have gone public in the last 20 years. Many of these newly listed companies were in high-tech industries, had no earnings, and did not pay dividends. But the influx of newly listed growth companies does not fully explain the declining popularity of dividends. It seems that even large and profitable firms are somewhat less likely to pay a dividend than was once the case.

Share Repurchase

When a firm wants to pay out cash to its shareholders, it usually declares a cash dividend. The alternative is to repurchase its own stock. The reacquired shares may be kept in the company’s treasury and resold if the company needs money.

There is an important difference in the taxation of dividends and stock repurchases. Dividends are taxed as ordinary income, but stockholders who sell shares back to the firm pay tax only on capital gains realized in the sale. However, the Internal Revenue Service is on the lookout for companies that disguise dividends as repurchases, and it may decide that regular or proportional repurchases should be taxed as dividend payments.

There are three main ways to repurchase stock. The most common method is for the firm to announce that it plans to buy its stock in the open market, just like any other investor.6 However, sometimes companies offer to buy back a stated number of shares at a fixed price, which is typically set at about 20 percent above the current market level. Shareholders can then choose whether to accept this offer. Finally, repurchase may take place by direct negotiation with a major shareholder. The most notorious instances are greenmail transactions, in which the target of a takeover attempt buys off the hostile bidder by repurchasing any shares that it has acquired. “Greenmail” means that these shares are repurchased by the target at a price which makes the bidder happy to leave the target alone. This price does not always make the target’s shareholders happy, as we point out in Chapter 33.

Stock repurchase plans were big news in October 1987. On Monday, October 19, stock prices in the United States nose-dived more than 20 percent. The next day the board of Citicorp approved a plan to repurchase $250 million of the company’s stock. Citicorp was soon joined by a number of other corporations whose managers were equally concerned about the market crash. Altogether, over a two-day period these firms announced plans to buy back $6.2 billion of stock. News of these huge buyback programs helped to stem the slide in stock prices.

Figure 16.1 shows that since the 1980s stock repurchases have mushroomed and are now larger in value than dividend payments. As we write this chapter at the end of October 2001, large new repurchase programs have just been announced in the last two weeks by IBM ($3.5 billion), McDonald’s ($5 billion), and Citigroup ($5 billion). The biggest and most dramatic repurchases have been in the oil industry, where cash resources for a long time outran good capital investment opportunities. Exxon Mobil is in first place, having spent about $27 billion on repurchasing shares through year-end 2000.

6An alternative procedure is to employ a Dutch auction. In this case the firm states a series of prices at which it is prepared to repurchase stock. Shareholders submit offers declaring how many shares they wish to sell at each price and the company then calculates the lowest price at which it can buy the desired number of shares. This is another example of the uniform-price auction described in Section 15.3.

16.2 HOW DO COMPANIES DECIDE ON DIVIDEND PAYMENTS?

Lintner’s Model

In the mid-1950s John Lintner conducted a classic series of interviews with corporate managers about their dividend policies.9 His description of how dividends are determined can be summarized in four “stylized facts”:10

1.Firms have long-run target dividend payout ratios. Mature companies with stable earnings generally pay out a high proportion of earnings; growth companies have low payouts (if they pay any dividends at all).

2.Managers focus more on dividend changes than on absolute levels. Thus, paying a $2.00 dividend is an important financial decision if last year’s dividend was $1.00, but no big deal if last year’s dividend was $2.00.

3.Dividend changes follow shifts in long-run, sustainable earnings. Managers “smooth” dividends. Transitory earnings changes are unlikely to affect dividend payouts.

4.Managers are reluctant to make dividend changes that might have to be reversed. They are particularly worried about having to rescind a dividend increase.

Lintner developed a simple model which is consistent with these facts and explains dividend payments well. Here it is: Suppose that a firm always stuck to its target payout ratio. Then the dividend payment in the coming year (DIV1) would equal a constant proportion of earnings per share (EPS1):

DIV1 target dividend

target ratio EPS1

The dividend change would equal

DIV1 DIV0 target change

target ratio EPS1 DIV0

A firm that always stuck to its target payout ratio would have to change its dividend whenever earnings changed. But the managers in Lintner’s survey were reluctant to do this. They believed that shareholders prefer a steady progression in dividends. Therefore, even if circumstances appeared to warrant a large increase in their company’s dividend, they would move only partway toward their target payment. Their dividend changes therefore seemed to conform to the following model:

DIV1 DIV0 adjustment rate target change

adjustment rate (target ratio EPS1 DIV0)

The more conservative the company, the more slowly it would move toward its target and, therefore, the lower would be its adjustment rate.

9J. Lintner, “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,”

American Economic Review 46 (May 1956), pp. 97–113.

10The stylized facts are given by Terry A. Marsh and Robert C. Merton, “Dividend Behavior for the Aggregate Stock Market,” Journal of Business 60 (January 1987), pp. 1–40. See pp. 5–6. We have paraphrased and embellished.

Lintner’s simple model suggests that the dividend depends in part on the firm’s current earnings and in part on the dividend for the previous year, which in turn depends on that year’s earnings and the dividend in the year before. Therefore, if Lintner is correct, we should be able to describe dividends in terms of a weighted average of current and past earnings.11 The probability of an increase in the dividend rate should be greatest when current earnings have increased; it should be somewhat less when only the earnings from the previous year have increased; and so on. An extensive study by Fama and Babiak confirmed this hypothesis.12 Their tests of Lintner’s model suggest that it provides a fairly good explanation of how companies decide on the dividend rate, but it is not the whole story. We would expect managers to take future prospects as well as past achievements into account when setting the payment. As we shall see in the next section, that is indeed the case.

16.3 THE INFORMATION IN DIVIDENDS AND STOCK REPURCHASES

In some countries you cannot rely on the information that companies provide. Passion for secrecy and a tendency to construct multilayered corporate organizations produce asset and earnings figures that are next to meaningless. Some people say that, thanks to creative accounting, the situation is little better for some companies in the United States.

How does an investor in such a world separate marginally profitable firms from the real money makers? One clue is dividends. Investors can’t read managers’ minds, but they can learn from managers’ actions. They know that a firm which reports good earnings and pays a generous dividend is putting its money where its mouth is. We can understand, therefore, why investors would value the information content of dividends and would refuse to believe a firm’s reported earnings unless they were backed up by an appropriate dividend policy.

Of course, firms can cheat in the short run by overstating earnings and scraping up cash to pay a generous dividend. But it is hard to cheat in the long run, for a firm that is not making enough money will not have enough cash to pay out. If a firm chooses a high dividend payout without the cash flow to back it up, that firm will ultimately have to reduce its investment plans or turn to investors for additional debt or equity financing. All of these consequences are costly. Therefore, most managers don’t increase dividends until they are confident that sufficient cash will flow in to pay them.

11This can be demonstrated as follows: Dividends per share in time t are

(1) DIVt aT(EPSt) (1 a)DIVt 1

where a is the adjustment rate and T is the target payout ratio. But the same relationship holds in t 1:

We can make similar substitutions for DIVt 2, DIVt 3, etc., thereby obtaining

DIVt aT(EPSt) aT(1 a)(EPSt 1) aT(1 a)2(EPSt 2) . . . aT(1 a)n(EPSt n)

12E. F. Fama and H. Babiak, “Dividend Policy: An Empirical Analysis,” Journal of the American Statistical Association 63 (December 1968), pp. 1132–1161.

There is some evidence that managers do look to the future when they set the dividend payment. For example, Benartzi, Michaely, and Thaler found that dividend increases generally followed a couple of years of unusual earnings growth.13 Although this rapid growth did not persist beyond the year in which the dividend was changed, for the most part the higher level of earnings was maintained and declines in earnings were relatively uncommon. More striking evidence that dividends are set with an eye to the future is provided by Healy and Palepu, who focus on companies that pay a dividend for the first time.14 On average earnings jumped 43 percent in the year that the dividend was paid. If managers thought that this was a temporary windfall, they might have been cautious about committing themselves to paying out cash. But it looks as if they had good reason to be confident about prospects, for over the next four years earnings grew on average by a further 164 percent.

If dividends provide some reassurance that the new level of earnings is likely to be sustained, it is no surprise to find that announcements of dividend cuts are usually taken by investors as bad news (stock price falls) and that dividend increases are good news (stock price rises). For example, in the case of the dividend initiations studied by Healy and Palepu, the announcement of the dividend resulted in an abnormal rise of 4 percent in the stock price.15

Notice that investors do not get excited about the level of a company’s dividend; they worry about the change, which they view as an important indicator of the sustainability of earnings. In Finance in the News we illustrate how an unexpected change in dividends can cause the stock price to bounce back and forth as investors struggle to interpret the significance of the change.

It seems that in some other countries investors are less preoccupied with dividend changes. For example, in Japan there is a much closer relationship between corporations and major stockholders, and therefore information may be more easily shared with investors. Consequently, Japanese corporations are more prone to cut their dividends when there is a drop in earnings, but investors do not mark the stocks down as sharply as in the United States.16

The Information Content of Share Repurchase

Share repurchases, like dividends, are a way to hand cash back to shareholders. But unlike dividends, share repurchases are frequently a one-off event. So a company that announces a repurchase program is not making a long-term commitment to earn and distribute more cash. The information in the announcement of a share repurchase program is therefore likely to be different from the information in a dividend payment.

Companies repurchase shares when they have accumulated more cash than they can invest profitably or when they wish to increase their debt levels. Neither

13See L. Benartzi, R. Michaely, and R. H. Thaler, “Do Changes in Dividends Signal the Future or the Past,” Journal of Finance 52 (July 1997), pp. 1007–1034. Similar results are reported in H. DeAngelo, L. DeAngelo, and D. Skinner, “Reversal of Fortune: Dividend Signaling and the Disappearance of Sustained Earnings Growth,” Journal of Financial Economics 40 (1996), pp. 341–372.

14See P. Healy and K. Palepu, “Earnings Information Conveyed by Dividend Initiations and Omissions,” Journal of Financial Economics 21 (1988), pp. 149–175.

15Healy and Palepu also looked at companies that stopped paying a dividend. In this case the stock price on average declined by an abnormal 9.5 percent on the announcement and earnings fell over the next four quarters.

16The dividend policies of Japanese keiretsus are analyzed in K. L. Dewenter and V. A. Warther, “Dividends, Asymmetric Information, and Agency Conflicts: Evidence from a Comparison of the Dividend Policies of Japanese and U.S. Firms,” Journal of Finance 53 (June 1998), pp. 879–904.

Stock repurchases may also be used to signal a manager’s confidence in the future. Suppose that you, the manager, believe that your stock is substantially undervalued. You announce that the company is prepared to buy back a fifth of its stock at a price that is 20 percent above the current market price. But (you say) you are certainly not going to sell any of your own stock at that price. Investors jump to the obvious conclusion—you must believe that the stock is good value even at 20 percent above the current price.

When companies offer to repurchase their stock at a premium, senior management and directors usually commit to hold onto their stock.18 So it is not surprising that researchers have found that announcements of offers to buy back shares above the market price have prompted a larger rise in the stock price, averaging about 11 percent.19

16.4 THE DIVIDEND CONTROVERSY

We have seen that a dividend increase indicates management’s optimism about earnings and thus affects the stock price. But the jump in stock price that accompanies an unexpected dividend increase would happen eventually anyway as information about future earnings comes out through other channels. We now ask whether the dividend decision changes the value of the stock, rather than simply providing a signal of stock value.

One endearing feature of economics is that it can always accommodate not just two but three opposing points of view. And so it is with the controversy about dividend policy. On the right there is a conservative group which believes that an increase in dividend payout increases firm value. On the left, there is a radical group which believes that an increase in payout reduces value. And in the center there is a middle-of-the-road party which claims that dividend policy makes no difference.

The middle-of-the-road party was founded in 1961 by Miller and Modigliani (always referred to as “MM” or “M and M”), when they published a theoretical paper showing the irrelevance of dividend policy in a world without taxes, transaction costs, or other market imperfections.20 By the standards of 1961 MM were leftist radicals, because at that time most people believed that even under idealized assumptions increased dividends made shareholders better off.21 But now MM’s proof is generally accepted as correct, and the argument has shifted to whether taxes or other market imperfections alter the situation. In the process MM have been pushed toward the center by a new leftist party which argues for low dividends. The leftists’ position is based on MM’s argument modified to take account

18Not only do managers’ hold onto their stock; on average they also add to their holdings before the announcement of a repurchase. See D. S. Lee, W. Mikkelson, and M. M. Partch, “Managers Trading around Stock Repurchases,” Journal of Finance 47 (1992), pp. 1947–1961.

19See R. Comment and G. Jarrell, op. cit.

20M. H. Miller and F. Modigliani: “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business 34 (October 1961), pp. 411–433.

21Not everybody believed dividends make shareholders better off. MM’s arguments were anticipated in 1938 in J. B. Williams, The Theory of Investment Value, Harvard University Press, Cambridge, MA, 1938. Also, a proof very similar to MM’s was developed by J. Lintner in “Dividends, Earnings, Leverage, Stock Prices and the Supply of Capital to Corporations,” Review of Economics and Statistics 44 (August 1962), pp. 243–269.