The previous post was titled “Dividends and Dividend Policy for Private Companies: An Introduction.”  In that post, we reviewed the fact that dividends are a residual of Earnings and Net Cash Flow that are available to be paid out to the owners of a business.  This post will focus on seven critical things you need to know about your company’s dividend policy.  In summary:

1. Every company has a dividend policy
2. Dividend policy influences return on business investment
3. Dividend policy is a starting point for portfolio diversification
4. Special dividends enhance personal liquidity and diversification
5. Dividend policy does matter for private companies
6. Dividend policy focuses management attention on financial performance
7. Boards of directors need to establish thoughtful dividend policies

Now, we focus on each of these seven critical things you need to know about your company’s dividend policy.

1. Every Company Has a Dividend Policy

Let’s begin with the obvious observation that your company has a dividend policy.  It may not be a formal policy, but, believe me, you have one.  Every year, every company earns money (or not) and generates cash flow (or not).  Assume for the moment that a company generates positive Earnings as we defined the term in the last post.  If you think about it, there are only three things that can be done with the earnings of a business:

• Reinvest the earnings in the business, either in the form of working capital, plant and equipment, software and computers, and the like, or even excess or surplus assets.
• Pay down debt.
• Pay dividends to owners (or economic distributions – after pass-through taxes – for S corporations and LLCs).

That’s it.  Those are all the choices.  Every business will do one or more of these things with its Earnings each year.  If a business generates excess cash and reinvests in CDs or other investments, or accumulates other non-operating assets, it is reinvesting in the business, although likely not at an optimal return on the reinvestment.  So even if your business does not pay a dividend to you and your fellow owners, you have a dividend policy and your dividend payout ratio is 0% of Earnings.

On the other hand, if your business generates substantial cash flow and does not require significant reinvestment to grow, it may be possible to have a dividend policy of paying out 90% or even 100% of earnings in most years.

Recall that if a business pays discretionary benefits to its owners that are above market rates of compensation, or if it pays significant expenses that are personal to the owners in their nature, it is the economic equivalent of paying a dividend to owners.  So when talking to business owners where such expenses are significant, I remind them that they are, indeed, paying dividends and should be aware of that fact.

Some may think that discretionary expenses are the provenance of only small businesses; however, they exist in many businesses of substantial size, even into the hundreds of millions in value.

I don’t make this point to suggest that discretionary expenses are necessarily bad.  I make the point to remind owners that those expenses are not the direct fruits of their labors, but are, in fact, dividends.  They should be considered as such when boards of directors are making decisions regarding dividend policies.

2. Dividend Policy Influences Return on Business Investment

To see the relationship between dividend policy and return on investment we can examine a couple of equations.  This brief discussion is based on a lengthier discussion in one of my books.  There is a basic valuation equation, referred to as the Gordon Model, which, simply stated, says that the Price (P) of a security is its Dividend (D₁) capitalized at its discount rate (R) minus its expected growth rate in the dividend (G_d).  This model is expressed as follows:

P₀ = D₁ / (R – G_d)

D1 is equal to Earnings times the portion of earnings paid out, or the dividend payout ratio (DPO), so we can rewrite the basic equation as follows:

P₀ = Earnings x DPO / (R – G_d)

What this equation says is that the more that a company pays out in dividends, the less rapidly it will be able to grow, because G_d, or the growth rate in the dividend is actually the expected growth rate of earnings based on the relevant dividend policy.

We can look at this simplistically in word equations as follows:

Dividend Income + Capital Gains = Total Return

Dividend Yield + Growth = Cost of Equity (or the discount rate, R)

The interesting thing is that these equations reflect basic corporate finance principles that pertain, not only to public companies, but to private businesses, as well.  There is an important assumption in all of the above equations – cash flow not paid out in dividends is reinvested in the business at its discount rate, r.

There are many examples of successful public companies that, for whatever reasons the controlling owners may have, do not pay any or any significant dividends, even in the face of unfavorable reinvestment opportunities.  To the extent that dividends are not paid and earnings are reinvested in low-yielding assets, the accumulation of excess assets will tend to dampen the return on equity and investment return for all shareholders.

Further, the accumulation of excess assets dampens the relative valuation of companies, because Return on Equity (ROE) is an important driver of value.  For example, I offer the following relationship without proof:

ROE X Price/Earnings Multiple = Price/Book Value

At a given multiple of earnings available in the marketplace, a company’s ROE will determine its Price/Book Value multiple.  The Price/Book Value multiple tells how valuable a company is in relationship to its book value, or the cost value of its shareholders’ investments in the business.  To the extent that a company’s dividend policy influences its ongoing Return on Equity, it influences its relative value in the marketplace and the ongoing returns its shareholders receive.

In short, your dividend policy influences your return on investment in your business.

3. Dividend Policy is a Starting Point for Portfolio Diversification

I’ve stated previously that this series of articles will form the basis for the second edition of The One Percent Solution.  The original booklet is available free at the upper right portion of this blog.  A quick read of the e-book will talk about the importance of wealth diversification for closely held business owners.  The concept of diversification is also discussed here.

In the last post, I told the story of being asked to help develop dividend policy for a private company.  The company had grown rapidly for a number of years, and its growth and diversification opportunities in the auto parts supply business were not as attractive as they had been.  The CEO and majority shareholder realized this and also that his sons (his fellow shareholders) could benefit from a current return on their investment in the company, which, collectively, was significant.

We reviewed the dividend policies of all of the public companies that we believed to be reasonably comparable to the company.  I don’t recall the exact numbers now, but I believe that the average dividend yield for the public companies was in the range of 3%.  As I analyzed the private company, it was clear that it was still growing somewhat faster than the publics, so the ultimate recommendation for a dividend was about 1.5% of value.

The value that the 1.5% dividend yield was compared to was the independent appraisal that we prepared each year.  Based on the value at the time, I recall that the annual dividend began at something less than $500 thousand per year.  But for the father and the sons, it was a beginning point for diversification of their portfolios away from total concentration in a private, although successful, business.

Your dividend policy can be the starting point for wealth diversification, or it can enhance the diversification process if it is already underway.

4. Special Dividends Enhance Personal Liquidity and Diversification

A number of years ago, I was an adviser to a smallish, publicly traded bank holding company. Because of past anemic dividends, this bank had accumulated several million dollars of excess capital.  The stock was very thinly traded and the market price was quite low, reflecting a very low Return on Equity (remember the discussion above).

Because of the very thin market for shares, a stock repurchase program was not considered workable.  After some analysis, I recommended that the board of directors approve a large, one-time special dividend.  At the same time I suggested they approve a small increase in the ongoing quarterly dividend.  I spoke in terms of providing shareholders with liquidity and the opportunity to diversify their holdings.

Since the board of directors collectively held a large portion of the stock, the discussion of liquidity and diversification opportunities, while maintaining their relative ownership position in the bank was attractive.

At the board meeting, one of the directors did a little bit of math.  He noted that if they paid out a large special dividend, the bank would lose earnings on those millions and earnings would decline.  I agreed with his math, but pointed out (calculations already in the board package) that the assets being liquidated were very low in yield and that earnings (and earnings per share) would not decline much.  With equity being reduced by a larger percentage, the bank’s Return on Equity should increase. So that increase in ROE, given a steady Price/Earnings multiple in the marketplace, should increase the bank’s Price/Book Value multiple.

The director put me on the spot.  He asked point blank: “What will happen to the stock price?”  I told him that I didn’t know for sure but that it should increase somewhat and, if the markets believed that they would operate similarly in the future, it could increase a good bit.  And the stock price increased more than 20% following the special dividend.

Special dividends, to the extent that your company has excess assets, can enhance personal liquidity and diversification.  They can also help increase value under the right circumstances.  That’s the best of all worlds.

5. Dividend Policy Does Matter for Private Companies

Someone once said that earnings are a matter of opinion, but dividends are a matter of fact. What we know is that when dividends are paid, the owners of companies enjoy their benefit and can pay their taxes and make individual choices regarding their reinvestment or consumption.

While the total return from an investment in a business equals its dividend yield plus capital gains (on beginning value), the return from dividends are current and bankable. They reduce the uncertainty of achieving returns. Further, if a company’s growth has slowed because of relatively few good reinvestment opportunities, a healthy dividend policy can help assure continuing favorable returns overall.

Based on many years of working with closely held businesses, I have observed that companies that do not pay dividends and, instead, accumulate excess assets, tend to have lower returns over time. There is, however, a more insidious issue. Companies that maintain lots of excess assets may tend to get lazy-minded.  Worse, however, is the opposite tendency. With lots of cash on hand, it is too easy to make a large and perhaps unwise investment that will not only consume the excess cash but detract from returns in the remainder of the business.

Dividend policy is the throttle by which well-run companies gauge their speed of reinvestment. If investment opportunities abound, then a no- or low dividend payout may be appropriate.  However, if reinvestment opportunities are slim, then a heavy dividend payout may be entirely appropriate.

Any way you cut it, dividend policy does matter for private companies.

6. Dividend Policy Focuses Management Attention on Financial Performance

Boards of directors are generally cautious with dividends and once a regular dividend is being paid, is reluctant to cut the dividend. The need, based on sound policy, to pay out 35% of earnings in the form of shareholder dividends (example only) will focus management’s attention on generating sufficient earnings each year to pay the dividend and to make necessary reinvestments in the business to keep it growing.

No management (even if it is you) wants to have to tell a board of directors (even if you are on it) that the dividend may need to be reduced or eliminated because of poor financial performance.

7. Boards of Directors Need to Establish Thoughtful Dividend Policies

If dividend policy is the throttle with which to manage cash flow not needed for reinvestment in a business, it makes sense to handle that throttle carefully and thoughtfully.  Dividends, or cash payments to shareholders, can come in the form of cash payments or in the form of share repurchases.

While a share repurchase is not a cash dividend, it does provide cash to selling shareholders and offsetting benefits to remaining shareholders.  A previous post provided an example of a substantial, leveraged share repurchase from a controlling shareholder to provide liquidity and diversification.

From a theoretical and practical standpoint, the primary reason to withhold available dividends today is to reinvest to be able to provide larger future dividends – and larger in present value terms today.  It is not a good dividend policy to withhold dividends for reasons like the following:

• A patriarch withholds dividends to prevent the second (or third or more) generations from being able to have access to funds.
• A control group chooses to defer dividends to avoid making distributions to certain minority shareholders.
• Dividends are not paid because management (and the board) want to build a large nest egg against possible future adversities.
• Dividends are not paid to accumulate excess or nonoperating assets on the balance sheet for personal or vanity reasons.

Dividend policy is important and your board of directors needs to establish a thoughtful dividend policy for your business.

 Wrapup Thoughts

Dividends and dividend policies are important for the owners of closely held and family businesses.  Dividends can provide a source of liquidity and diversification for owners of private companies.  And dividend policy can have an impact on the way that management focuses on financial performance.

If you would like to discuss dividend policy, or would like a presentation to your board of directors regarding dividend policy, give me a call.  This could be an important conversation for you and your fellow owners.

As always, if you wish to talk with me about any business or valuation-related matters, or to discuss management or ownership transition issues in complete confidence, give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time,

Chris