Good Dividend Policy

A good dividend policy might look like this:

1. Management determines the financial structure of the firm. For example, they decide upon a leverage () of 2.5. This translates into 60% debt and 40% equity.
2. Management looks at the investments it wishes to make, and at its requirements for working capital growth. For example, suppose it needs to grow current assets by $5 million and buy $20 million of new plant. To maintain its 60/40 structure, it needs 40% x ($5 + $20) million = $10 million in new equity.
3. It can get the equity by retaining profits or by issuing stock. If profits are expected to be $10 million or more, management can use profits alone to grow the company. There is one complication to consider, “did we pay dividends last year?” If so, it may wish to maintain the past dividend. Suppose that 2 million share are outstanding. $10 million divided by 2 million shares produces an EPS of $5.00. If last year’s dividend were $2.00 per share, that would leave $3.00 time’s 2 million shares or $6 million for new, retained earnings. The remaining $4 million would be raised in a stock issue. Of course, this is a policy decision. Management could choose to cut the dividend and avoid the stock issue.

In short, dividends should represent the “excess” profits that are not required for growth in working capital and new plant. Consider the alternative. If you keep the profits and do not put them to use, your financial structure must change. Idle assets, especially cash, will accumulate. You will feel pressure to do something with the cash. Teams often pay down debt, which further affects the financial structure. Instead of making financial policy, they observe it.

Returning to stock price, a dividend can be compared to the interest payment on a bond. Given the payment and the interest rate, we can easily determine the principal. Since dividends can be volatile, Capstone® stockholders look at last year’s dividend (up to last year’s EPS) and this year’s dividend (also up to this year’s EPS) and calculate an average dividend.