Payout Policy in the 21st Century

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Payout Policy in the 21st Century
July 9, 2004 Tuck Conference on Corporate Finance

• Alon Brav
• Duke University, Durham, NC USA
• John R. Graham
• Duke University, Durham, NC USA
• Campbell R. Harvey
• Duke University, Durham, NC USA
• National Bureau of Economic Research, Cambridge,
  MA USA
• Roni Michaely
• Cornell University, Ithaca, NY USA
• IDC, Israel

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Brav/Graham/Harvey/Michaely Payout Policy
Introduction

• In 1956, John Lintner laid the foundation for the
  modern understanding of dividend policy
• He conducted detailed interviews with 28
  companies
• His research helped set the agenda for
  theoretical and empirical research on dividend
  policy
• Much has changed in the last 50 years.
• Possibly different payout policy goals
• Repurchases
• More insights from theory that may help direct
  the spotlight in the right direction
• We revisit this path-breaking study at the
  beginning of the 21st century

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Brav/Graham/Harvey/Michaely Payout Policy
Introduction

• We survey 384 financial executives with an
  instrument that focuses on both dividends and
  repurchases
• 256 public, 128 private
• Most presented results are based on the public
  firms
• We conduct one-on-one interviews with 23 CFOs or
  Treasurers of prominent corporations
• Interviews last between 40 minutes and two hours

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Brav/Graham/Harvey/Michaely Payout Policy
Methodology
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Brav/Graham/Harvey/Michaely Payout Policy
Methodology

• Survey and Interview Design
• Draft survey instrument refereed by both
  finance researchers and experts in survey design
• Interviewed structured to adhere to best
  scientific practices of interviews, e.g. Sudman
  and Bradburn (1983)

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Brav/Graham/Harvey/Michaely Payout Policy
Methodology

• Survey Delivery
• Survey CFOs, Treasurers, Finance VPs
• Primarily members of Financial Executives
  International
• Two 500 random winners
• Three surveys
• FEI CFO Forum (April 23, 2002, Co. Springs CO)
• Dave Ikenberry NFCF (May 1, 2002, Houston TX)
• Mass emailing to 2200 FEI members
• Overall 16 response rate

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Brav/Graham/Harvey/Michaely Payout Policy How
are payout decisions made?

• Goals of Treasury department
• Fund investment
• MM
• Liquidity and possible contingencies
• Payout decisions are second-order
• Except...
• DO NOT CUT DIVIDENDS ranks equal to or above all
  of these items

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Brav/Graham/Harvey/Michaely Payout Policy
Payout vs. Investment Decisions
Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy
Dividends vs. Repurchases (Fig. 2)
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Brav/Graham/Harvey/Michaely Payout Policy
Complements or Substitutes?

• Level of dividend fixed
• Substitute repurchases for change in dividends
• One way substitution
• Would use even more repurchases if they were free
  of constraint of dividend history

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Brav/Graham/Harvey/Michaely Payout Policy
Lintner (1956)

• Three main points
• Target payout ratio (dividend/earnings)
• Dividend policy set conservatively
• partial adjustment to target payout
• smooth through time
• sticky (history important)
• Level given, focus on changes
• tied to long-run sustainable earnings
• do not increase now if you might have to cut
  later
• No repurchases

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Brav/Graham/Harvey/Michaely Payout Policy
Compare to Lintner (1956)

• Dividend policy still conservative?
• Yes
• Perceived big penalty for cut, small reward for
  increase
• So, smooth, to avoid future cuts
• Path dependence of dividend policy
• BUT
• stealth dividend cut if possible
• holding dividend constant OK

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Brav/Graham/Harvey/Michaely Payout Policy
Payout Decisions Still Made Conservatively? vs.
Lintner (1956)
Repurchases No, flexible Dividends Yes, still
conservative
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Brav/Graham/Harvey/Michaely Payout Policy
Conservatively increase payout? Similar to
Lintner (1956)?
Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
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Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)
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Brav/Graham/Harvey/Michaely Payout Policy
Payout ratio still target? vs. Lintner (1956)

• Extension of Fama-Babiak (1968), Choe (1990)
• The SOA and TP .
• Both SOA and TP have declined through time using
  both matching sample to our survey and broader
  Compustat sample

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Brav/Graham/Harvey/Michaely Payout Policy
Summary vs. Lintner (1956)

• Dividend policy still very conservative
• Modern cash cows live in (close to) Lintner world
• Repurchase policy is not (i.e., it is more
  flexible)
• Payout ratio no longer target
• Targets very flexible
• Repurchases now very important

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Brav/Graham/Harvey/Michaely Payout Policy
Miller and Modigliani (1961)

• Payout Policy irrelevant if capital markets
  perfect
• Imperfections that could explain payout policy
• Taxes
• Managerial agency conflict
• Information/signaling
• Other factors (EPS, float, credit ratings, etc)
• Clienteles could result from imperfections

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Brav/Graham/Harvey/Michaely Payout Policy A.
Taxes

• Theory At least for individual investors,
  dividends are taxed move heavily than capital
  gains.
• Therefore
• Firms should consider investors taxation when
  deciding about payout policy
• Relative taxation should affect the amount of
  dividends they pay

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Brav/Graham/Harvey/Michaely Payout Policy A.
Taxes

• Interviews repurchases are efficient way to
  return capital
• taxes (2nd order) important
• Surveys modest support

Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles

• Investors that pay (relatively) more taxes on
  dividends should hold stocks that pay out through
  repurchases.
• Translation Individual investors should have an
  aversion to dividend paying stocks. By
  implications, institutions should be more
  attracted to such stocks.
• Prudent man
• Institutions as monitors

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Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles

• Retail investors
• Prefer dividends, in spite of tax disadvantage
• Firms like because loyal
• Institutions
• If anything, prefer repurchases
• Some can not invest in zero dividend stocks
• 42 say pay dividends because of prudent man
  rules
• Tax advantage not an issue to institutions
• Firms like because they have the money

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Brav/Graham/Harvey/Michaely Payout Policy B.
Clienteles

• Companies do not think that dividends attract
  institutions more so than do repurchases
• Companies do not use dividends or repurchases
  attract institutions to monitor
• Inconsistent with Allen, Bernardo, and Welch
  (2000) idea that firms use dividends to attract
  institutional investors

Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy C.
Agency Stories

• Firms pay dividends to impose discipline on
  managers

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Brav/Graham/Harvey/Michaely Payout Policy C
Free Cash Flow

• Interviews some say money can burn hole in
  pocket
• But payout not the way to fix the problem
• Surveys (1) no support in general, (2)
  repurchases work as well as dividends but (3)
  Cash cows are much more likely to pay more
  reluctant to cut more likely to keep dividend
  growth as earnings growth

Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy D.
Asymmetric Information

• Conveying information
• Costly self-imposed actionSignaling
• Adverse selection
• Do informed investors benefit from repurchase
  programs, at expense of uninformed?
• Stock undervaluation

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Brav/Graham/Harvey/Michaely Payout Policy D
Do payout decisions convey information?

• Interviews Yes, punctuation mark at end of
  sentence
• Need to be consistent with other forms of
  communication
• Repurchases convey as much as dividends
• Surveys Yes, convey info in general

Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy
Information Signaling
Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy D.
Information Signaling

• Surveys
• No supporting evidence
• Scores are even lower for growth/risky firms
• 39 (16) say keep div (repurchase) policy of
  peers
• Interviews
• Spent hours on this issue
• Generally try to group selves with peers (not
  separate)
• No evidence of
• increasing dividend to show market that firm is
  strong
• viewing dividend as self-imposed cost
• Avoiding dividend cut
• Possibly a signal (costly for bad firms, separate
  from bad)
• Cuts are rare cant explain dividend policy for
  most firms
• Does not explain why firms pay dividends in the
  first place

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Brav/Graham/Harvey/Michaely Payout Policy D.
Information Stock Price

• Interviews Would like to buy when price low, but
  
• often want to maintain liquidity at this time
• do not want credit rating downgrade
• So, its a conditional objective
• Surveys repurchases, stock good investment

Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy E.
Other factors EPS

• Interviews managers are concerned about EPS
• Some think its automatic that repurchases
  increase EPS
• Other believe that it depends on alternative use
  of funds
• Surveys EPS important

Repurchase questions
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Brav/Graham/Harvey/Michaely Payout Policy E.
Other factors Float and credit ratings

• Interviews Float very important
• Execs think they need to have a large number of
  shareholders
• Interviews credit rating important
• Hoard cash to improve rating
• Especially for financial firms or firms with
  financial divisions

Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy
Initiate with repurchases or dividends?
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Brav/Graham/Harvey/Michaely Payout Policy Why
initiate payout?
Repurchases Dividends
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Brav/Graham/Harvey/Michaely Payout Policy
Conclusions

• Payout policy is not first-order important (MM)
• Repurchases decided de novo
• Dividends level very important
• Managers prefer repurchases over dividends
  because they are more flexible.
• Not because of taxes.

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Brav/Graham/Harvey/Michaely Payout Policy
Conclusions

• According to managers, payout
• convey information
• NOT being used as a costly signal
• NOT being used to attract institutions
• Managers do not use dividends over repurchases to
  attract institutions
• Institutions do not push for more dividends

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Brav/Graham/Harvey/Michaely Payout Policy
Conclusions

• Managers of cash cows believe more strongly that
• Dividends should be stable
• Keeping dividend growth rate with earnings growth
• But all managers reject the notion that they need
  dividends so that they will not spend cash
  unwisely.

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Brav/Graham/Harvey/Michaely Payout Policy Rules
of the Game How payout policies are determined

• Make investment plans first
• Take care of cash/liquidity needs
• BUT, remember, level of dividends fixed
• Only reduce dividends in extraordinary
  circumstances
• Severe penalty for cutting dividend because the
  market believes that cuts precede bad news
• So, dont ever cut dividends
• unless you have an amazing investment opportunity
• smaller penalty if competitors cut
• Think very carefully before initiating dividends

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Brav/Graham/Harvey/Michaely Payout Policy Rules
of the Game

• Desire to maintain the level of dividend at any
  cost consistent with findings in Graham, Harvey
  and Rajgopal, 2004, The Economic Implications
  of Corporate Financial Reporting
• Here managers desire to hit consensus EPS at any
  cost
• 55 would knowingly sacrifice value (not pursue a
  very positive NPV project) if it would cause the
  firm to miss next quarters target!
• 78 would knowingly sacrifice value to smooth
  earnings