A simple question, I’m sure you’ll reply. Everyone knows that a dividend is money paid to shareholders by a company to reward them for owning its shares. However, a non-executive director needs to know a little more than this, as dividends can prove surprisingly complex.
A dividend is a form of shareholder distribution. However it is not the only form of distribution, the main alternative being a share buy-back. I’ll come back to that in a later article.
The first question that needs to be asked is whether a shareholder distribution would be legal.
Is a dividend legal?
A company can distribute only profits to shareholders, so there must be sufficient accumulated profits in the balance sheet. This is shown by whether there are sufficient ‘distributable reserves’. If you look at the bottom of the balance sheet, you will see a number of reserve accounts listed, some of which are distributable and others not. The accounting bodies have conspired to make this highly complex, so I won’t go into the details here. However an alert non-exec will ask the CFO or Audit Partner to list out the distributable reserves to show that they exceed the shareholder distribution being proposed.
Be careful here, in that the distribution is made out of the top company accounts, not the group consolidated ones, so look at these (it may be the only time you look at the ‘company’ accounts, usually buried right at the back of an Annual Report). Also be aware that it has to be the last filed accounts that show sufficient reserves. Management accounts don’t count, nor does any profit earned after the last set of accounts filed with Companies House.
It is illegal for UK companies to pay a shareholder distribution that does not meet these conditions. If you subsequently find that an illegal distribution has been made, you will have to either claim it back from shareholders (not a great idea) or pass a retrospective EGM resolution to absolve shareholders from any claim from the company to get the money back. Best not get yourself into this position, although it does happen, especially since the law has been tightened.
Do shareholders like dividends?
There’s not much point in paying a dividend unless shareholders want one, but it’s pretty rare for them to be unpopular. Dividends do three things;
- Pass some of the profits onto the owners of the business (ie shareholders)
- Reduce cash balances or increase net debt for the company
- Signal confidence in the future to the market
Dividend cover: Companies normally pay out a proportion of their annual profits. This is shown by the dividend cover. A common level is a cover of 2.0 meaning that the profit after tax is twice the dividend, or to put it another way, the company is paying out half its post tax profit. As a rough rule of thumb, a non-exec should be wary if the company is paying out a lot more than this (ie cover well below 2.0). Shareholders value a stable and predictable dividend flow, so you should satisfy yourself that this level is sustainable. It is possible to have an uncovered dividend (ie the dividend is higher than the profit, a cover of less than 1.0), but it is very difficult to keep this going for long.
If the cover is 3.0 or above, shareholders may query why more isn’t paid out. There may of course be good reasons, perhaps the company is trying to reduce its borrowings or is nervous about the future.
Dividend yield: The other way to look at dividend return is expressing the annual dividend as a percentage of the share price. This is the dividend yield. It can be compared to an interest on a savings account. Shareholders might expect a yield to be higher than a savings account to take account of the risk of fluctuations in the share price. A typical dividend yield at the time of writing is 3.5%, well above most savings returns.
Shareholder might be happy with a lower dividend yield if they expect the share price to rise, perhaps as the company is investing its cash resources into expanding the business. On the other hand, a higher dividend yield may not be good news, as this may suggest that the market expects the share price to fall and indeed that the dividend may not be sustainable.
Different shareholders look for different returns. Most private (“retail”) shareholders look for income, and so favour stocks that deliver at least a market average dividend yield. This would also be true of institutional income funds. However growth funds are more focussed on the share price, and so may be relatively indifferent to the dividend.
Do dividends matter?
Theoretically dividends shouldn’t matter. It’s all shareholders money whether its distributed (dividends) or kept in the business (share price). Shareholders should worry only about total shareholder return (TSR), which is share price appreciation plus dividends paid. A higher or lower dividend should not affect TSR.
However, in practice, dividends do matter:
- A shareholder might have tax advantages in receiving capital gains from a rising share price, rather than income from dividends.
- Shareholder distribution may be part of the company moving to a different capital structure, such as increasing debt and leverage. This alters the risk profile of the company and may move the valuation of the stock.
- A rising dividend is sending the market a sign about management confidence and this may be reflected in a higher share price. Alternatively a cut in the dividend suggests that management is foreseeing more difficult times ahead.
Other kinds of dividend
Dividend in kind: Some companies offer investors to receive dividends in shares, either through a scrip issue of new shares or a ‘DRIP’ scheme (whereby the company purchases existing shares to give to investors). The advantages to shareholders are that, if they don’t need the cash immediately, they can reinvest the money in additional shares with no dealing costs. The advantage of a scrip issue to the company is that it preserves its cash, effectively issuing new equity. The DRIP uses cash, but slightly reduces the shares in issue, with some benefit to earnings per share. In the UK there is no tax difference in taking a cash dividend versus shares. If a new scrip or DRIP scheme is being launched, a non-exec should just ask what level of take-up is expected in order to justify the modest additional costs for the company.
Special dividend: Sometimes a company will declare a special dividend. The description ‘special’ simply implies one-off. It is typically where the company wishes to pass on the proceeds of a sale of a major asset or division, or where it wishes to increase significantly its gearing or reduce its spare cash. In other respects a special dividend is the same as an ordinary dividend.
Dividends can be a surprisingly complex area. They need to be thought about and pitched at the right level for the cash resources, strategy and future expectations of a company.
- Always ask the question about distributable reserves before approving a shareholder distribution.
- Ask how the share register is made up, especially between income and growth investors.
- If the proposed dividend cover is less than 2, ask the question why such a high pay-out and is this is sustainable?
- If the proposed dividend cover is higher than 3, ask why the dividend is restricted to this level and could a higher payout be afforded?
- If the dividend yield is higher than 4, ask why. Does the market expect a dividend cut in the future?
- Asking the question doesn’t mean it’s wrong. It will just elicit the information a non-exec needs to understand before approving a shareholder distribution.