The dividend route to disaster

Abnormally high dividend pay-outs may harm not only the company but also the market and the economy

It is raining dividends! And pouring in some quarters. As reported in this paper (Business Standard, June 7), the dividend ratios of several companies have gone up significantly, with many top payers more than doubling these in FY23. This is generally good news for shareholders, who are happy, and for the market and the economy. Promoters and promoter group entities, holding substantial shareholding in some of those companies, are happier, since in absolute terms they receive huge amounts.

However, a company’s dividend distribution policy, even in the case of dividend stocks, is not solely about maximising the dividend of shareholders. It has multiple dimensions and therefore it is important to have a holistic and long-term vision while deciding on distributing net profit and/or free reserves. From a corporate governance perspective, dividend distribution policy has to be in perfect harmony with the investment and growth plans of a company. A company as a living entity has to grow in a sustainable manner while sharing part of its gains with shareholders.  Therefore, apart from saving for rainy days, it is important to plan in advance for growth and diversification, and adapt to rapid changes in technology, especially in increasingly complex and uncertain times like the present.

A dividend payout ratio measures the dividend per share versus the earnings per share. Inverting the payout ratio shows how much profit the company plans to retain. There may be industry-specific or ownership-specific factors which may vary the results, but as a general principle, a high payout ratio can be a sign that dividends may not be sustainable over the longer term. Earnings that are retained within the business should serve as a buffer for future expectations. Therefore, businesses that do not reinvest will likely face headwinds in the future.

Many companies, particularly cash-rich tech companies, distributing a sizeable part of their net profit, may be having adequate reserves to take care of their future growth plans. Given their human resource-intensive nature, they may not need significant capital expenditure. However, it appears that some other companies, which need substantial capital investments for their growth, are dipping deeper into their reserves to fund abnormally high dividend pay-outs.

Despite reported declines in profits, several companies have paid dividends 100 times the face value and/or more than three times the profits. It is also important to note that some of them are not resorting to other forms of corporate rewards such as buybacks. It appears that the enlarged size of the dividend cake is conditioned on the fund requirements of the promoter/promoter groups having large shareholding. This is a dangerous trend as a sanguine, balanced dividend distribution policy should not have any “related party” considerations behind it, whether explicit or implied. Such considerations, even passively, would undermine the foundation of a company and its future completely, which is not in the medium- or long-term interest of the shareholders, ironically, including the same short-term bounty-seeking promoter shareholders. Incidentally, promoter shareholders seeking high dividend pay-outs appear to be common to both the public and private sectors, without any class divide on this front.

Each company is a living legal person having its own rights and responsibilities. It has the right to ensure that the people who are discharging its functions (the board) act responsibly on its behalf and its larger stakeholder system. The main protagonist in this stakeholder ecosystem is the company itself, as decisions adverse to it affect all others too. Investors  should be aware of the potential dividend value trap, which is like instant gratification at the cost of long-term prospects of the business.

Though the board of directors of a company is empowered under the Companies Act, 2013, to decide on the share of profits and/or free reserves as dividends, the Act also lays down certain principles and conditions for such distribution under section 123. The basic premise describing such a principle is to ensure that the board of directors of a company should not be guided by promoter needs and irrational exuberance, among other things, when distributing dividends. The expectation is to distribute a reasonable part of the net profit. This reasonable part is generally considered optimum if it is between 35 per cent and 55 per cent of the net profit.

While the magnitude of profit and dividend distribution over the years as well as the immediate capital expenditure plan might influence this optimum ratio, the golden rule is that a significant part of the net profit should be ploughed back. Over a longer horizon, depending on plans for reinvesting and assessment of risk, the accumulated surplus can be used for special dividends. But, regular distribution of dividend has to be disciplined, consistent and follow the basic principles of prudence as the “life and health” of the company and its sustainability are at stake.  It also impacts the investors in terms of intergenerational equity.

Dividend payment as a bonanza by some companies, irrespective of the underlying reason, will distort capital allocation and equity investment in favour of such companies and at times against many balanced, well-governed companies, unleashing an undesirable incentive-disincentive structure in the capital market. This is neither the intention of the law nor good for the capital market and the economy. It will generate tremendous pressure on every company to follow suit, unleashing an unhealthy, competitive dividend distribution approach bypassing prudence and principles. That will convert the “perpetual life” of companies into a short-term mode.

Raining dividends is healthy and fine, but cloudbursts from some parts of the corporate sky are too risky for those companies, long-term investors, the health of the capital market, and sometimes the economy.

The writers are, respectively, director and professor at NISM