Investing in a Dividend Boost

Investing in a Dividend Boost

Havard Business Review     
July - August 1967     
By Gary MacDougal     
It can raise the price of a company’s stock and reduce the number of shares to be used for an acquisition or secondary offering.

The merits of alternative investment projects in terms of their probable return are customarily subjected to sophisticated analysis. Few corporations, however, are using the ROI concept in determining their dividend payouts, the author says. In this article he proposes a method by which management can apply an investment approach to dividend policy, without forgetting the importance of stability. Mr. MacDougal has been an Associate in McKinsey & Company’s Los Angeles office since 1963. He specializes in corporate strategic growth planning, with emphasis on mergers and acquisitions.

The dividend payout is of prime concern to the chief executive officer and the board of directors in every publicly held company. Frequently the conflicting claims of money market dividend needs and internal financial requirements pose a dilemma that must be satisfied by some kind of compromise.

The importance of this problem and the dramatic effect of dividend decisions on a company’s operations are readily apparent. The top 20 industrials in Fortune’s “500” list paid out more than 4.5 billion in dividends last year. Suppose 10% of this amount had been retained and invested in projects promising a return on investment of 12% or more. What would have been the effect on the companies and their shareholders? What would have been the impact of a 10% higher dividend payout?

Perhaps because it is difficult to answer these questions, companies usually tend to stick to historical dividend pattern or make intuitive adjustments to reflect changes in earning performance. Often, as one study has shown, there is an implicit target payout fraction of earning (e.g. 30% or 40%), and as earning increase (or decrease), last year’s dividend is adjusted to move toward this target. Recognition of the value that the money market places on dividend stability underlies most approaches.

New Approach
Without ignoring the need for stability, an investment approach to dividend decisions provides the fundamental analytical tools that in many situations can result in an improved overall utilization of corporate earnings. The investment approach maintains that dividend determination can and should be viewed as an investment decision.

A wide variety of investment projects are available to the typical company. Their merits in terms of probable return—and hence their respective claims on retained earnings—vary; and companies are increasingly turning to sophisticated techniques, such as discounted cash flow return on investment, for selecting the best alternatives and for allocating retained earnings (and other cash sources) rationally among them. Comparable approaches to the inextricably related decision on dividend payout—which determines the proportion of earnings available for other investment projects—are certainly in order. But corporate practice lags in this respect.

In this article I shall describe one investment approach, and propose a method by which top management can determine dividend policy on a more analytical basis and put it into the same framework as other avenues of investment open to a corporation.