Dividend policy

John Lintner's dividend policy model is a model theorizing how a publicly-traded company sets its dividend policy. The logic is that every company wants to maintain a constant rate of dividend even if the results in a particular period are not up to the mark. The assumption is that investors will prefer to receive a certain dividend payout.

The model states that dividends are paid according to two factors. The first is the net present value of earnings, with higher values indicating higher dividends. The second is the sustainability of earnings; that is, a company may increase its earnings without increasing its dividend payouts until managers are convinced that it will continue to maintain such earnings. The theory was adopted based on observations that many companies will set their long-run target dividends-to-earnings ratios based upon the amount of positive net-present-value projects that they have available.

The model then uses two parameters, the target payout ratio and the speed where current dividends adjust to that target:

  ${\displaystyle {\begin{aligned}D_{t}&=D_{t-1}+\rho \cdot \left(D_{t}^{*}-D_{t-1}\right)\\&=D_{t-1}+\rho \cdot \left(\tau \cdot E_{t}-D_{t-1}\right)\\&=\rho \cdot \tau \cdot E_{t}+(1-\rho )\cdot D_{t-1}\\&=\rho \cdot D_{t}^{*}+(1-\rho )\cdot D_{t-1}\end{aligned}}}$

where:

• ${\displaystyle D_{t}}$ is the dividend per share at time ${\displaystyle t}$
• ${\displaystyle D_{t-1}}$ is the dividend per share at time ${\displaystyle (t-1)}$, i.e. last year's dividend per share
• ${\displaystyle \rho }$ is the speed of adjustment rate or the partial adjustment coefficient, with ${\displaystyle 0\leq \rho \leq 1}$
• ${\displaystyle D_{t}^{*}}$ is the target dividend per share at time ${\displaystyle t}$, with ${\displaystyle D_{t}^{*}=\tau \cdot E_{t}}$
• ${\displaystyle \tau }$ is the target payout ratio on earnings per share (or on free-cash-flow per share), with ${\displaystyle 0\leq \tau \leq 1}$
• ${\displaystyle E_{t}}$ is the earnings per share (or free-cash-flow per share) at time ${\displaystyle t}$

When applying its model to U.S. stocks, Lintner found ${\displaystyle \rho \simeq 30\%}$ and ${\displaystyle \tau \simeq 50\%}$.

The capital structure substitution theory (CSS)[1] describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share (EPS) are maximized. The resulting dynamic debt-equity target explains why some companies use dividends and others do not. When redistributing cash to shareholders, company managements can typically choose between dividends and share repurchases. But as dividends are in most cases taxed higher than capital gains, investors are expected to prefer capital gains. However, the CSS theory shows that for some companies share repurchases lead to a reduction in EPS. These companies typically prefer dividends over share repurchases.

From the CSS theory it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than

  ${\displaystyle {\frac {D}{E_{\text{q}}}}>{\frac {1-T_{\text{C}}}{1-T_{\text{D}}}}-1}$

should prefer dividends as a means to distribute cash to shareholders, where

• D is the company's total long-term debt
• ${\displaystyle E_{\text{q}}}$ is the company's total equity
• ${\displaystyle T_{\text{C}}}$ is the tax rate on capital gains
• ${\displaystyle T_{\text{D}}}$ is the tax rate on dividends

Low-valued, high-leverage companies with limited investment opportunities and a high profitability use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.[2]

The CSS theory provides more guidance on dividend policy to company managements than the Walter model and the Gordon model. It also reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa. The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way.