Distributions to Shareholders
A profitable company regularly faces three important questions. (1) How much of its free cash flow should it pass on to shareholders? (2) Should it provide this cash to stockholders by raising the dividend or by repurchasing stock? (3) Should it maintain a stable, consistent payment policy, or should it let the payments vary as conditions change?
In this post I will discuss the issues that affect a firm’s cash distribution policy. As we will see, most firms establish a policy that considers their forecasted cash flows and forecasted capital expenditures, and then try to stick to it. The policy can be changed, but this can cause problems because such changes inconvenience the firm’s stockholders and send unintended signals, both of which have negative implications for stock prices. Still, economic circumstances do change, and occasionally such changes require firms to change their dividend policies.
One of the most striking examples of a dividend policy change occurred in May 1994, when FPL Group, a utility holding company whose primary subsidiary is Florida Power & Light, announced a cut in its quarterly dividend from $0.62 per share to $0.42. At the same time, FPL stated that it would buy back 10 million of its common shares over the next three years to bolster its stock price.1 Security analysts called the FPL decision a watershed event for the electric utility industry. FPL saw that its circumstances were changing—its core electric business was moving from a regulated monopoly environment to one of increasing competition, and the new environment required a stronger balance sheet and more financial flexibility than was consistent with a 90 percent payout policy.
What did the market think about FPL’s dividend policy change? The company’s stock price fell by 14 percent the day the announcement was made. In the past, hundreds of dividend cuts followed by sharply lower earnings had conditioned investors to expect the worst when a company reduces its dividend—this is the signaling effect, which is discussed later in the chapter. However, over the next few months, as they understood FPL’s actions better, analysts began to praise the decision and to recommend the stock. As a result, FPL’s stock outperformed the average utility and soon exceeded the preannouncement price.