Creating the Correct Dividend Policy

“I believe non-dividend stocks aren’t much more than baseball cards. They are worth what you can convince someone to pay for it.” – Mark Cuban, investor and owner of the NBA’s Dallas Mavericks

Directors can use dividends to convey confidence and attract yield-hungry investors, but they must strike a balance between payouts and future growth.

Dividends are an important part of the capital management strategy at many banks, and the operating environment has made yield more important to analysts and investors. A bank’s dividend policy is a highly visible signal of management’s confidence to deliver consistent results. The board of directors is responsible for determining a bank’s cash dividend; it is paramount they strike the right payout.

After carefully considering regulatory capital requirements, a board still has a fair amount of discretion when establishing the dividend policy while retaining sufficient funds for growth. Boards often weigh dividends against share repurchases to manage capital. However, trading multiples and capital levels heavily influence stock repurchases, which tend to be more discretionary than regular dividend payments. A lower tax rate on dividends and ordinary income is another factor that favors dividends over share repurchases.

Dividends can be a good measure of corporate governance. A dividend payout policy means that investors can worry less about unchecked growth or inefficient investments that do not maximize shareholder value.

Optimal Dividend Policy
The appropriate capital management policy can help a bank achieve an optimal trading multiple. The optimal dividend policy depends on a company’s earnings growth, capital requirements and ability to communicate its strategy to the investment community. Although cash dividends have been historically respected by bank investors, the prolonged low interest rate environment and the perception that banks are increasingly utility-like has elevated the importance of dividend payouts.

There is, however, an opportunity cost of using cash to pay out dividends rather than fuel growth initiatives. And an increased dividend can indicate that management expects higher future cash flows and possibly higher future valuations.

The Federal Reserve’s monetary policy encourages yield-hungry investors to favor stocks over fixed-income instruments. Given the current economic and interest rate environment, equity investors can achieve the safety of bonds through a combination of cash dividends and any upside from capital appreciation inherent in stocks. Dividend popularity has increased, due to respectable corporate cash flows, more favorable tax rates, and broad consumer confidence in the economy and stock market. Currently, the S&P 500 dividend yield is around 1.86 percent, compared to a 2.4 percent yield on 10-year Treasury notes.

In response to these considerations, management should determine the retention ratio, which lies in the earnings power above the dividend payment. Effectively measuring market, liquidity and credit risk—often done through stress testing—is vital to determining the margin of protection a bank needs to ensure the consistency of dividend payments. The DuPont formula, where return on equity equals return on assets times the equity multiplier, should underpin the financial perspective.

Industry-wide challenges like continued pressure on net interest margins and a diminishing ability to trim reserves will stretch the safety margin in the current environment. Banks with slower earnings growth need to carefully determine their dividend payout ratios. Increasing or stable dividends are generally positive signals to the market regarding the institution’s financial condition and prospects, while a dividend cut could paint a negative picture.

Changing Investor Views
The attitudes of analysts and the investment community regarding dividends have come full circle. This was not always the case, as investors preferred that banks retain capital for growth or to fund stock repurchases.

Retail investors, including executives and members of the board, are attracted to community bank stocks because of the sector’s predictable dividend payments. Directors would be well advised to focus on their bank’s dividend policy and the efficient use of capital as part of their fiduciary duties to shareholders.