Our latest podcast deep-dives into the recent empirical results in relation to corporate payout management (specifically, cash dividends and share repurchases).
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This fun podcast is about 10 minutes long (with smart AI podcast generation from Google NotebookLM).
https://bit.ly/3PZJQ9a
This corporate payout literature review rests on the recent survey article by Farre-Mensa, Michaely, and Schmalz (2014). Out of the conventional motives of why the typical firm makes cash payout in the form of both dividends and repurchases (cf. the agency, signaling, and tax stories), the cross-sectional evidence is most persuasive in favor of agency considerations. Some recent studies of the May 2003 dividend tax cut sconfirm that differences in the separate taxation of dividends and capital gains have at best a second-order impact on setting corporate cash payout. None of the conventional payout explanations can account for the secular changes in how corporate payout materializes over the past few decades. During this time, share repurchases have replaced dividends as the primary vehicle for corporate payout (Fama and French, 2001; DeAngelo, DeAngelo, and Skinner, 2004; Skinner, 2008). More recent theoretical and empirical developments of corporate payout literature focus on cash distributions of regular and smooth dividends and market-timing repurchases as an integral part of the firm’s larger financial ecosystem with important implications for corporate investment, capital structure, cash management, risk management, managerial rent protection, and corporate ownership and governance (e.g. Lambrecht and Myers (2012, 2015)).
Farre-Mensa, Michaely, and Schmalz (2014) summarize several primary empirical facts about corporate cash distributions. Corporate cash distributions entail substantial dollar amounts that reflect large wealth transfers in the economy. For instance, U.S. public firms pay $800+ billion in dividends and repurchases. For better exposition, the bullet points below sum up these empirical facts:
Share repurchases have increased substantially to dominate dividends as the major form of corporate payout since 2004. Now more firms repurchase shares than pay cash dividends, and firms distribute more cash to their shareholders via stock buyback than dividend payout (DeAngelo, DeAngelo, and Skinner, 2004; Skinner, 2008).
The number of public firms that pay cash dividends has substantially decreased from the mid-1980s to the early-2000s, and this trend has reversed with the reappearance of dividends in the past decade because public firms need to pay out conventional cash dividends to assure outside investors when these firms mature over their financial lifecycle (Fama and French, 2001; DeAngelo, DeAngelo, and Skinner, 2004; Julio and Ikenberry, 2004). Large and profitable firms pay more dividends than risky firms that face more growth opportunities (Fama and French, 2001; DeAngelo, DeAngelo, and Skinner, 2004; Skinner, 2008). Share repurchases are more widespread across firms than dividends while a relatively small number of firms pay out most aggregate dividends. Specifically, the top 25 firms pay out well more than half of aggregate dividends. This dividend concentration is an empirical observation that cannot be easily explained by a lower propensity for the typical firm to pay cash dividends or a structural shift in the composition of new lists (Fama and French, 2001; DeAngelo, DeAngelo, and Skinner, 2004).
A robust pattern that has persisted over the last century is that corporations reveal a firm commitment to maintaining the level of dividend payout. Regular cash dividends are sticky and smooth over time, particularly among large and profitable firms (Lintner, 1956; Skinner, 2008; Michaely and Roberts, 2011; Leary and Roberts, 2011). In contrast, share repurchases are heavily pro-cyclical and tend to exhibit much more variability throughout the business cycle (Grullon and Michaely, 2002, 2004).
The typical firm’s stock buyback decision does not exclusively reflect a desire to pay out excess cash to shareholders. Rather, the desire to undo the EPS dilution that arises from stock option exercises or direct equity grants to employees, executive managers, and directors appears to play a first-order role in the share repurchase decision (Bens, Nagar, Skinner, and Wong, 2003).
The stock market reacts positively to increases in both dividend payout and share buyback. Also, the stock market responds negatively to decreases in both dividend payout and share buyback. Moreover, the stock market reaction to dividend increases and decreases is asymmetric: the average abnormal returns in response to dividend increases and decreases are 1.34% and –3.71% respectively (Grullon, Michaely, and Swaminathan, 2002). There is some evidence in support of a high propensity for the typical firm to cater to relative stock market misvaluation that reveals either a dividend premium or a dividend discount. In the former case of a dividend premium, the median firm is inclined to initiate dividend payout. In the latter case of a dividend discount, however, the median firm appears to omit dividend payout. This behavioral catering theory predicts binary dividend initiation or omission but not the magnitude of dividend payout (Baker and Wurgler, 2004, 2012).
The evidence supports the agency prediction that most firms use corporate payout to reduce potential overinvestment by corporate incumbents (Ikenberry, Lakonishok, and Vermaelen, 1995; Nohel and Tarhan, 1998). Firms increase their cash distributions when these firms mature over time (DeAngelo, DeAngelo, and Skinner, 2004; Julio and Ikenberry, 2004). The stock market reacts positively to high dividend payout and share buyback that these mature and profitable firms initiate with their abundant free cash flows (Grullon and Michaely, 2004; Baker and Wurgler, 2004, 2012).
Fama and French (2001) empirically find that the fraction of public firms that pay out cash dividends has decreased substantially from 66.5% in 1978 to 20.8% in 1999. Part of this decline is due to a structural shift in the population of public firms toward small firms with low profitability and robust asset growth. This structural shift arises from an explosion of new lists from 3,638 in 1978 to 5,670 in 1997. The low profitability of these new lists explains at least part of the decline in the fraction of public dividend payers.
Furthermore, Fama and French (2001) run logit regressions to gauge the propensity for the typical firm to pay out cash dividends. After the econometrician controls for a unique set of firm characteristics such as profitability, asset growth, market-to-book, and size, the typical firm’s much lower propensity to pay out dividends explains half of the drastic decline in the fraction of public dividend payers. Specifically, the typical firm’s propensity to pay cash dividends declines by about 25% while the actual decline in the fraction of public dividend payers is nearly 50%. In essence, this lower propensity to pay out dividends is as important as the structural shift in firm composition in explaining the decrease in the proportion of public dividend payers.
Grullon and Michaely (2002) and DeAngelo, DeAngelo, and Skinner (2004) empirically report that the decline in the number of public dividend payers suggests an increase in the overall dividend concentration with a 22.7% increase in the real dollar amount of dividend payout by industrial firms from 1978 to 2000. Also, Grullon and Michaely (2002) propose the substitution hypothesis that many public firms nowadays successfully substitute cash dividends with share repurchases as the dominant form of corporate payout. DeAngelo, DeAngelo, and Skinner (2004) wisely observe that the large reduction in the number of public dividend payers occurs almost entirely among firms that pay relatively small dividends while there is a simultaneous substantial increase in cash dividend payout by the largest dividend payers. As a result, the increase in real dividend payout by large and more profitable firms at the top of the dividend distribution swamps by a broad margin the reduction in real dividend payout by small and unprofitable firms at the bottom of the dividend distribution. During the same time period, the aggregate increase in net income significantly outpaces the increase in real dividend payout and thus results in a systemic decline in both the dividend payout ratio and the dividend yield (Grullon and Michaely, 2002).
DeAngelo, DeAngelo, and Skinner (2004) find that NYSE firms pay the majority of industrial dividends. This empirical fact suggests the tendency for older and more stable firms that pay regular dividends to list their shares on NYSE. In contrast, young and risky firms that are less likely to pay regular dividends list their shares on AMEX and NASDAQ. Dividend concentration can arise from the recent concentration of corporate income supply (Linter, 1956; DeAngelo, DeAngelo, and Skinner, 2004). The top 25 dividend payers distribute more than 55% of the aggregate cash dividends. It is noteworthy that 14 of these top 25 dividend-payers are large, stable, and mature Dow Jones industrial firms. However, the vast majority of dividend non-payers are high-tech growth firms with high future income potential. In essence, DeAgnelo, DeAngelo, and Skinner’s (2004) empirical results help demystify the puzzle of *dividend disappearance* from Fama and French’s (2001) landmark study.
Skinner (2008) empirically finds that changes in the corporate income cross-section help explain changes in both dividend payout and share buyback from 1980 to 2005. Moreover, share repurchases increasingly substitute for dividends (both for dividend payers and sole share repurchasers). A special group of firms comprises profitable firms that pay both smooth annual dividends and regular repurchases. These firms dominate the distribution of both corporate net income and dividend payout, with well over half of these aggregates in the recent years. These firms commit to their regular dividend distributions mainly due to an implicit obligation to continue this dividend smoothing practice (Brav, Graham, Harvey, and Michaely, 2005). While these profitable firms use both cash payout mechanisms, these firms increasingly substitute share repurchases for dividends. Over the biennial window, corporate income helps explain the variation in the level of stock buyback, and corporate managers time repurchases over this period (Brav, Graham, Harvey, and Michaely, 2005; Peyer and Vermaelen, 2009). Share repurchases are flexible enough to boost earnings per share (EPS) (Bens, Nagar, Skinner, and Wong, 2003) or to distribute cash for the avoidance of potential agency conflicts (Jensen, 1986; Harford, Humphery-Jenner, and Powell, 2012).
Over the period from 1980 to 2005, firms that only pay dividends have declined from 13% to 7% of the number of firms and from 8% to 2% of all dividend and repurchase distributions. This evidence further supports the secular trend that repurchases substitute for dividends. Overall, Skinner’s (2008) empirical results accord with the substitution hypothesis that share repurchases have become the dominant form of corporate payout in comparison to cash dividends. The use of share repurchases as the dominant payout mechanism at least partly helps demystify the EPS dilution puzzle.
Biennial Lintner (1956) regressions of changes in dividend or total payout on both corporate income and past dividend or total payout suggest a structural shift in the empirical relation between corporate income and cash payout. Over the subperiods 1980-1994 to 1995-2005, the dividend mean-reversion is slow and steady at a rate less than –25% while the total payout mean-reversion has significantly increased in speed from –31% to –71%. While the typical firm pays a cash dividend of 9 cents per dollar of corporate income in 1980-1994 and a cash dividend of 17 cents per dollar of corporate income in 1995-2005 (p-value>0.27), the typical firm’s total payout increases from 26 cents per dollar of corporate income in 1980-1994 to 56 cents per dollar of corporate income in 1995-2005 (p-value<0.01). In this light, Skinner (2008) attributes this significant difference to the discretionary use of share repurchases. Total payout more closely tracks corporate income over time since the typical firm increasingly uses stock buyback to absorb the variation in corporate income. In sum, dividend payments increase smoothly over time and are largely independent of the variation in corporate income while share repurchases increasingly absorb this variation.
Bliss, Cheng, and Denis (2015) report significant reductions in both dividend payout and share buyback during the 2008-2009 financial crisis. Repurchase reductions prevail to a larger extent than dividend cuts. Payout reductions are more likely in firms with higher leverage, more valuable growth options, and lower cash balances (i.e. these firms are more susceptible to the negative consequences of an external financing shock). Firms appear to use the proceeds from payout reductions to maintain cash reservoirs for financing future firm investment opportunities. In this light, an external shock to the supply of credit (net of demand effects) during the financial crisis increases the marginal benefit of cash retention. Payout reductions in general, and repurchase reductions in particular, serve as a substitute form of corporate finance.
During the 2008-2009 financial crisis, the percentage of firms that either reduce or eliminate dividends increases from 6% in 2006 to 25% in 2009 while the percentage of firms that curb repurchases increases from 52% in 2006 to 89% in 2009. In contrast to cash dividends, share repurchases can be viewed as a flexible form of corporate payout. Bliss, Cheng, and Denis’s (2015) logit regressions of the indicator for payout reductions as well as panel regressions of payout reductions shed light on the evidence of payout reductions as a substitute form of corporate finance. This result echoes some recent studies of corporate cash and payout decisions (Brav, Graham, Harvey, and Michaely, 2005; Campello, Graham, and Harvey, 2010; Leary and Michaely, 2011; Almeida, Campello, and Weisbach, 2004; Faulkender and Wang, 2006; Bates, Kahle, and Stulz, 2009; Harford, Mansi, and Maxwell, 2014; La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000; Dittmar and Mahrt-Smitth, 2007; Harford, Mansi, and Maxwell, 2008):
To the extent that corporate incumbents have a high propensity to smooth regular dividend payments, Brav, Graham, Harvey, and Michaely (2005) document survey evidence that CFOs would rather cut investment than cut dividend payout when their firms face severe financial constraints. Further, these CFOs view the financial flexibility of share buyback as one of its primary attributes. This flexibility distinguishes share buyback from dividend payout, the latter of which induces the firm to commit to the same or even higher dividend payout in the future.
According to Campello, Graham, and Harvey’s (2010) survey evidence, CFOs note that firms often bypass attractive and valuable investment opportunities due to borrowing constraints during a major financial crisis. Leary and Michaely (2011) observe that unlike the case for cash dividends, corporate managers do not appear to make any attempt to smooth share repurchases through time. Bliss, Cheng, and Denis’s (2015) empirical results fit well with this general observation because the financial flexibility that arises from payout reductions during the financial crisis originates primarily from reductions in share repurchases. In comparison, dividend cuts are one of the more costly sources of financial flexibility.
Under the precautionary motive for holding cash, firms build up cash stockpiles as a valuable buffer against exogenous shocks to corporate cash flows or investment opportunities. Hence, firms tend to hold greater cash balances when these firms face more costly external finance, when corporate cash flows are more volatile, and when firm investment opportunities are more valuable. Several recent studies suggest that cash balances positively correlate with cash flow volatility, market-to-book, and multiple measures of constrained access to external capital (Opler, Pinkowitz, Stulz, and Williamson, 1999). Over the past few decades, the dramatic increase in corporate cash retention is attributable to a sharp increase in cash flow volatility (Bates, Kahle, and Stulz, 2009). Also, firms exhibit a greater propensity to save cash from their cash flows when these firms face higher costs of external finance (Almeida, Campello, and Weisbach, 2004). Moreover, the marginal value of cash is greater in firms with limited access to external capital markets than in firms that face less severe financial constraints (Faulkender and Wang, 2006). All this evidence bolsters the precautionary motive story for corporate cash retention.
Corporate managers have some perverse incentives to retain excessive free cash flows because this excess enables incumbents to divert corporate resources for greater private benefits of control to the detriment of outside investors (Jensen, 1986; Stulz, 1990; La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000). In accordance with this agency story of free cash flows, Harford, Mansi, and Maxwell (2008) empirically find that firms with weak corporate governance spend excess cash on acquisitions and capital expenditures more quickly than do firms with better corporate governance. Furthermore, Dittmar and Mahrt-Smith (2007) find that every one dollar of cash in poorly governed firms is worth only 42-88 cents while good governance doubles this cash value. Firms with poor governance tend to dissipate cash quickly in several ways that significantly hurt operating performance. This negative impact of excessive cash reserves on future operating performance can be cancelled out if the typical firm improves its governance practices.
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