Topic 7: On dividends and shares buy backs.

Dividend policy is one of the most debated issues in finance: although much research has been done to investigate the existence of a superior dividend payout policy, a clear cut answer has not emerged, with evidence that is at times contradictory.

The debate revolves around three main standpoints: those that argue that paying dividends increases the value of a firm, those that argue that it decreases the value of a firm and those that argue that it has no impact on a firm’s value.

Proponents of the first hypothesis claim that investors have a natural preference for stocks that provide high returns and that cash is best returned to investors, rather than left to the company’s management, that may or may not invest it in projects that increase the future profitability of the firm.

Those that argue against high dividend payouts note that taxation on dividends is heavier than on capital gains, and in this sense the latter is a more efficient way for firms to provide returns to investors. Proponents of low, or even zero dividend payouts are generally in favour of shares buybacks as a way to return funds to investors.

Finally, a third group sees dividends as the difference between capital expenditure and retained earnings (capital expenditure is netted out of the portion that can be financed through debt). If the firm wants to increase its dividend payout to investors beyond the difference between retained earnings and capital expenditure, it must issue new shares that end up diluting the value of the shares owned by the investor that received the increased dividend. The two effects offset each other, leaving the firm’s value unaffected (and an investor can always reinvest his or her dividend to avoid dilution).

Research such as that from Arnott and Asness (2003) found evidence against the claim that high earning retention leads to an increase in the growth rate of future earnings. In this sense, their research is consistent with the claims of high payout proponents, according to whom management may end up engaging in empire-building activities with retained earnings, and that these are better off returned to investors. On the contrary, subsequent research from Ap Gwilym, Seaton and Thomas (2005) has found that high-dividend portfolios with a high payout ratio and zero-dividend portfolios do not outperform each other on a risk-adjusted basis. This is consistent with the third hypothesis set out above. Given the impossibility of resolving the dividend policy debate through empirical evidence, it may be useful to accept the heterogeneity that exists in the market, where different stocks have different dividend policies and turn our attention to the dynamics that drive dividends. Here evidence is a less ambiguous. First of all, there is strong evidence that dividends are sticky, i.e. that payouts lag behind earnings by several periods. Research from Brav, Graham, Harvey and Michaely (2005) on a sample of nearly 400 executives of listed firms found that dividends are not set independently as a result of earnings, but that the majority of executives set dividends in relation to level of the previous year, often adjusting other decisions to avoid lowering dividends. This idea has been modeled by Guttman, Kadan and Kandel (2010) as dividend pooling: they advance the hypothesis that a certain dividend level is not linked to the specific earnings attained over the period, but rather to a range of different values. In this sense, executives display a bias against change in dividend levels, particularly when the adjustment should occur downwards. Executives motivate this choice with the beliefs that stock prices have an in-built premium that reflects dividend stability, and that not smoothing dividends across periods would damage stock price. Chariotu, Lambertides and Theodoulou (2011) also find evidence that dividend stability is beneficial: they find that a firm with a strong record in terms of profitability and dividend payment that posts a loss, is more likely to return to profitability in the next period if it does not suspend dividend payments. This argument is not entirely convincing however: it may be the case that firms that continue paying out dividends to investors do so because they know that their loss is occasional and will not impact their long run earnings. In this sense, causation may run in the opposite direction than hypothesized. Notwithstanding the direction of the causation between dividends and earnings, it is clear that investor see the dividend payout as containing precious information about a company’s financial health. In this sense, executives may decide not to begin paying dividends in the first place, in case they may not be able to sustain the same level of payout in the future. This partly explains a phenomenon that has been on the rise since the 1990s, share buybacks: firms have begun to retire a portion of their outstanding shares instead of returning capital to shareholders in the form of a dividend. The first objection to share buybacks refers to the fact that unlike dividends, they do not treat investors equally (Smith, 2011); however, share buybacks also benefit those shareholders that do not participate in the program because they decrease the number of shares outstanding and thus increase future earnings per share. Another popular objection to share buybacks refers to the fact that they often tend to occur when shares are trading at relatively high prices, and in this sense they are a suboptimal method of returning funds to investors. Some even argue that the increase we are currently observing is share buy backs (Demos, 2011) is akin to managerial delinquency because executives are often paid in share options that are profitable only when the stock price goes above the strike price. In this sense, while paying dividends they would be effectively lowering the price of the stock, and thus their chance of making a profit from their options, by retiring some shares, they are effectively lowering the supply of the firm’s stock on the market and increasing its price.

On balance, without clear evidence on the impact of dividends on a firm’s value, dividends policy is likely to remain a matter of executive choice; executives and investors have a preference for stability and in this sense dividend smoothing remains a widely adopted practice among those companies that pay dividends regularly. Those that do not, are unlikely to begin to pay dividends in the near future given the uncertainty they face; as mentioned above, shareholders value dividend stability and it may be difficult for executives to suspend dividend payments without impacting the share price. In this sense, even though they are not without shortcomings, share buybacks represent an increasingly attractive way to return create value for investors not only because they can be easily terminated, but also because they are a relatively easy way to increase earnings per share in a stagnant operating environment.



  • Ap Gwilym, O. Seaton, J. and Thomas, S. (2005). Dividend Yield Investment Strategies, the Payout Ratio and Zero-Dividend Stocks. The Journal of Investing, Vol. 14(4) p.69-74;
  • Arnott, R. and Asness, C. (2003). Surprise! Higher Dividends = Higher Earnings Growth. Financial Analysts Journal, Vol. 59(1), p.70-87;
  • Brav, A. Harvey, C. Graham, J. and Michaely, R. (2005). Payout Policy in the 21th Century: The Data. Johnson School Research Paper Series No. 29-06. Available at SSRN:;
  • Charitiou, A. Lambertides, N. and Theodoulou, G. (2011). Losses, Dividend Reductions, and Market Reaction Associated with Past Earnings and Dividends Patterns. Journal of Accounting, Auditing & Finance, Vol. 26(2), p.351-382.
  • Demos, T. (2011). Surge in buy-backs by US companies, Financial Times, available online at;
  • Guttman, I. Kadan, O and Kandel, E. (2010). Dividend Stickiness and Strategic Pooling. Review of Financial Studies, Vol. 23(12), p.4455-4495;
  • Smith, A. (2011). Companies dig into share buy-backs. Financial Times, available online at

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