Dividend Stability

The stability of dividends is also important. Profits and cash flows vary over time, as do investment opportunities. Taken alone, this suggests that corporations should vary their dividends over time, increasing them when cash flows are large and the need for funds is low and lowering them when cash is in short supply relative to investment opportunities. However, many stockholders rely on dividends to meet expenses and they would be seriously inconvenienced if the dividend stream were unstable. Further reducing dividends to make funds available for capital investment could send incorrect signals and that could drive down stock prices. Thus, maximizing its stock price requires a firm to balance its internal needs for funds against the needs and desires of its stockholders.

How should this balance be struck: that is, how stable and dependable should a firm attempt to make its dividends? It is impossible to give a definitive answer to this question, but the following points are relevant:

1.    Virtually every publicly owned company makes a five to ten year financial forecast of earnings and dividends. Such forecasts are never made public they are used for internal planning purposes only. However, security analysts construct similar forecasts and do make them available to investors; see value line for an example. Further, virtually every internal five to ten year corporate forecast we have seen for a normal company projects a trend of higher earnings and dividends. Both managers and investors know that economic conditions may cause actual results to differ from forecasted results, but “normal” companies expect to grow.

2.    Years ago, when inflation was not persistent, the term “stable dividend policy” meant a policy of paying the same dollar dividend year after year. AT&T was a prime example of a company with a stable dividend policy - it paid $9 per year ($2.25 per quarter) for 25 straight years. Today, though most companies and stockholders expect earnings to grow over time as a result of retained earnings and inflation. Further, dividends are normally expected to grow more or less in line with earnings. Thus today a “stable dividend policy” generally means increasing the dividend at a reasonably steady rate. For example, Rubbermaid made this statement in a recent annual report:

Dividends per share were increased for the 34^th consecutive year out goal is to increase sales, earnings and per share by 15% per year, while achieving a 21% return on beginning shareholders equity. It is also the Company’s objective to pay approximately 30% of current year’s earnings as dividends, which will permit us to retain sufficient capital to provide for future growth.

Rubbermaid used the word “approximately” in discussing its payout ratio because ever if earnings vary a bit from the target level the company still planned to increase the dividend by the target growth rate. Even though Rubbermaid did not mention the dividend growth rate in the statement, analysts can calculate the growth rate and see that it is the same 15 percent as indicated for sales and earnings:

g=b(ROE)

=(1-Payout) (ROE)

=0.7(21%)=15%

Here b is the fraction of earnings that are retained, or 1.0 minus the payout ratio.

Companies with volatile earnings and cash flows would be reluctant to make a commitment to increase the dividend each year so they would not make such a detailed statement even so most companies would like to be able to exhibit the kind of stability Rubbermaid has shown, and they try to come as close to it as they can.

Dividend stability has two components: (1) How dependable is the growth rate, and (2) can we count on at least receiving the current dividend in the future? The most stable policy, from an investor’s standpoint, is that of a firm whose dividend growth rate is predictable such a company’s total return (dividend yield plus capital gains yield) would be relatively stable over the long run, and its stock would be a good hedge against inflation. The second most stable policy is where stockholders can be reasonably sure that the current dividend will not be reduced it may not grow at a steady rate, but management will probably be able to avoid cutting the dividend. The least stable situation is where earnings and cash flows are so volatile that investors cannot count on the company to maintain the current dividend over a typical business cycle.

3.    Most observers believe that dividend stability is desirable. Assuming this position is correct; investors prefer stocks that pay more predictable dividends to stocks which pay the same average amount of dividends but in a more erratic manner. This means that the cost of equity will be minimized and the stock price maximized, if a firm stabilizes its dividends as much as possible.