14.1 The Basics of Payout Policy ELEMENTS OF PAYOUT POLICY

LG 1 14.1 The Basics of Payout Policy ELEMENTS OF PAYOUT POLICY

payout policy The term payout policy refers to the decisions that firms make about whether to

Decisions that a firm makes

distribute cash to shareholders, how much cash to distribute, and by what regarding whether to distribute means the cash should be distributed. While these decisions are probably less cash to shareholders, how

important than the investment decisions covered in Chapters 10 through 12 and

much cash to distribute, and the means by which cash

the financing choices discussed in Chapter 13, they are nonetheless decisions

should be distributed.

that managers and boards of directors face routinely. Investors monitor firms’ payout policies carefully, and unexpected changes in those policies can have sig- nificant effects on firms’ stock prices. The recent history of Best Buy, briefly out- lined in the chapter opener, demonstrates many of the important dimensions of payout policy.

Like most rapidly growing firms, Best Buy decided not to pay any cash to shareholders for many years, preferring instead to reinvest the cash that the busi- ness generated to build and operate new stores. As the firm matured, managers decided that cash flow from operations was sufficient to continue to reinvest in growth and return some cash to shareholders. However, in Best Buy’s case, the decision to begin distributing cash to shareholders in 2003 was not driven entirely by the slowdown in the company’s growth rate. In addition, a significant change to the tax code that year made dividends much more attractive to investors on an after-tax basis. Best Buy’s largest shareholder at the time was its founder, Richard Schulze, who stood to receive about $20 million in dividends annually. Mr. Schulze would pay much less tax on these dividends after the 2003 tax law changes.

But dividends are not the only means by which firms can distribute cash to shareholders. Firms can also conduct share repurchases, in which they typically buy back some of their outstanding common stock through purchases in the open market. Best Buy, like many other companies, uses both methods to put cash in the hands of their stockholders. In its first year of paying out cash to share- holders, Best Buy paid $130 million in dividends and bought back $100 million worth of common stock. From 2005 through 2008, Best Buy actually distributed more cash via share repurchases than through dividends, but, when the financial crisis hit, the company temporarily eliminated all share repurchases while main- taining its quarterly dividend payments.

If we generalize the lessons about payout policy from Best Buy’s recent finan- cial history, we may expect that:

1. Rapidly growing firms generally do not pay out cash to shareholders.

2. Slowing growth, positive cash flow generation, and favorable tax conditions can prompt firms to initiate cash payouts to investors. The ownership base of the company can also be an important factor in the decision to distribute cash.

3. Cash payouts can be made through dividends or share repurchases. Many companies use both methods. In some years, more cash is paid out via divi- dends, but sometimes share repurchases are larger than dividend payments.

4. When business conditions are weak, firms are more willing to reduce share buybacks than to cut dividends.

PART 6

Long-Term Financial Decisions

FIGURE 14.1 Recessions Per Share Earnings and

Dividends of the S&P 500 Index

Earnings Monthly U.S. dollar amount of earnings and dividends per share of the S&P 500 Index from 1950 through the first quarter of 2010 (the figure uses a

Dividends logarithmic vertical scale)

(logarithmic scale)

Dollars per Share of the S&P 500 Index

TRENDS IN EARNINGS AND DIVIDENDS Figure 14.1 illustrates both long-term trends and cyclical movements in earnings and

dividends paid by large U.S. firms that are part of the S&P 500 stock index. The figure plots monthly earnings and dividend payments from 1950 through the first quarter of 2010. The top line represents the earnings per share of the S&P500 index, and the lower line represents dividends per share. The vertical bars highlight 10 periods during which the U.S. economy was in recession. Several important lessons can be gleaned from the figure. First, observe that over the long term the earnings and dividends lines tend to move together. Figure 14.1 uses a logarithmic scale, so that the slope of each line represents the growth rate of earnings or dividends. Over the 60 years shown in the figure, the two lines tend to have about the same slope, meaning that earnings and dividends grow at about the same rate when you take a long-term perspective. This makes perfect sense—firms pay dividends out of earn- ings, so for dividends to grow over the long-term, earnings must grow too.

Second, the earnings series is much more volatile than the dividends series. That is, the line plotting earnings per share is quite bumpy, but the dividend line is much smoother. This suggests that firms do not adjust their dividend payments each time earnings move up or down. Instead, firms tend to smooth dividends, increasing them slowly when earnings are growing rapidly and maintaining divi- dend payments, rather than cutting them, when earnings decline.

To see this second point more clearly, look closely at the vertical bars in Figure

14.1. It is apparent that during recessions corporate earnings usually decline, but dividends either do not decline at all or do not decline as sharply as earnings. In six of the last ten recessions, dividends were actually higher when the recession ended than just before it began, although the last two recessions are notable exceptions to this pattern. Notice also that, just after the end of a recession, earnings typically

563 Matter of fact

CHAPTER 14

Payout Policy

P&G’s Dividend History