When to pay a dividend?

Today we’ll look at how firms return excess cash to their shareholders, which normally happens through dividend payments or share re-purchases.

A business can be highly profitable and well run, and cash reserves can (hopefully) accumulate quickly. Hopefully the firm is looking out for growth and investment opportunities and can find investments that offer risk-adjusted returns higher than its cost of capital – in which case it should make those investments as they add value to the firm. However, firms don’t always have these opportunities and so the question becomes what to do with the excess cash they are building up? The core principle of finance is that if a firm doesn’t have attractive investment opportunities, it should return excess cash to shareholders who can then choose to invest elsewhere. Breaking this down into its parts helps us understand the issues

How much cash is ‘excessive’?

A business needs cash to finance its working capital cycle and to fund growth (the amount of funding that growth requires depends on the working capital cycle); it also needs to keep cash reserves that will enable it to withstand a severe knock – in most cases this is enough cash to cover 6 months operations with no income. Above this, the firm probably has excess cash and if it can’t find suitable projects to invest in then it should return the cash to shareholders.

How do we return it shareholders?

Cash can be returned to shareholders in the form of dividends or share repurchases. Dividends are the more common way to return cash, however they may carry secondary taxes that are paid by the company (this was the case in South Africa, but dividends are not taxable in the hands of the recipient). Dividends are treated as tax-free income in the hands of their recipients (having already been taxed as income to the firm and again with the secondary tax). A share repurchase is simply the opposite of issuing new shares in exchange for capital: in the repurchase the firm pays money to shareholders in exchange for their shares, which gives the shareholders a lump sum of cash and reduces the overall equity value of the firm. Keep in mind that reducing the equity in the firm by either dividends or share repurchases changes the capital structure of the firm in that it is more heavily geared subsequently.

What factors apply differently to small businesses than large companies?

In big companies, dividend policy is taken very seriously as it determines they type of investor who buys the shares in the firm. For example, investors who are either retired or nearing retirement tend to favour the steady cash flow of a predictable dividend than the potential of capital growth. This means that the pension funds in which they’ve invested in turn invest in shares that meet the preferred criteria of the investors in the fund. Other investors/funds (with typically younger investors) look for higher growth and don’t care much for dividends.

Generally, firms like to pay predictable dividends that grow each year while retaining sufficient cash for their growth. A large corporate who has large cash reserves might find themselves an attractive acquisition target, and would reduce their attractiveness by declaring a large dividend. As you can imagine, there are books on the subject, Doctorates to be earned and friendships to be lost in setting dividend policy.

In small companies, dividends are a much more fickle thing although they shouldn’t be. What I see too often is the owner who needs to refurbish his house or pool and draws cash from the business in order to do so, leading to the business growing more slowly or even struggling. I always stress how important it is to draw a firm line between business and personal finance, yet most entrepreneurs more or less have to blur this line in times of high business or personal financial needs. My advice regarding dividends is first to set a clear policy around determining how much cash should be held in the business (for example, 6 month’s working capital at any stage – or more for seasonal businesses). Make this dividend policy absolute and put it in the shareholders agreement. Then you have clarity and a policy – in good years you can look forward to a dividend and in bad years you’ll be protected from yourself by a firm policy amongst shareholders.

Remember to ask for help if anything here has confused you: @valuationup