Figure 14.1 illustrates both long-term trends and cyclical movements in earnings and dividends paid by large U.S. firms that are part of the Standard & Poor’s 500 Stock Composite Index. The figure plots monthly earnings and dividend payments from 1950 through the first quarter of 2013. The top line represents the earnings per share of the S&P 500 index, and the lower line represents dividends per share. The vertical bars highlight ten periods during which the U.S. economy was in recession. Several important lessons can be gleaned from the figure. First, observe that over the long term the earnings and dividends lines tend to move together. Figure 14.1 uses a logarithmic scale, so the slope of each line represents the growth rate of earnings or dividends. Over the 60 years shown in the figure, the two lines tend to have about the same slope, meaning that earnings and dividends grow at about the same rate when you take a long-term perspective. It makes perfect sense: Firms pay dividends out of earnings, so for dividends to grow over the long-term, earnings must grow too.

FIGURE 14.1 Per Share Earnings and Dividends of the S&P 500 Index

Monthly U.S. dollar amount of earnings and dividends per share of the S&P 500 index from 1950 through the first quarter of 2013 (the figure uses a logarithmic vertical scale)

Second, the earnings series is much more volatile than the dividends series. That is, the line plotting earnings per share is quite bumpy, but the dividend line is much smoother, which suggests that firms do not adjust their dividend payments each time earnings move up or down. Instead, firms tend to smooth dividends, increasing them slowly when earnings are growing rapidly and maintaining dividend payments, rather than cutting them, when earnings decline.

To see this second point more clearly, look closely at the vertical bars in Figure 14.1. It is apparent that during recessions corporate earnings usually decline, but dividends either do not decline at all or do not decline as sharply as earnings. In six of the last ten recessions, dividends were actually higher when the recession ended than just before it began, although the last two recessions are notable exceptions to this pattern. Note also that, just after the end of a recession, earnings typically increase quite rapidly. Dividends increase, too, but not as fast.

A third lesson from Figure 14.1 is that the effect of the recent recession on both corporate earnings and dividends was large by historical standards. An enormous earnings decline occurred from 2007 to 2009. This decline forced firms to cut dividends more drastically than they had in years; nonetheless, the drop in dividends was slight compared with the earnings decrease.

Matter of fact

P&G’s Dividend History

Few companies have replicated the dividend achievements of the consumer products giant Procter & Gamble (P&G). P&G has paid dividends every year for more than a century, and it increased its dividend in every year from 1956 through 2012.


When firms want to distribute cash to shareholders, they can either pay dividends or repurchase outstanding shares. Figure 14.2 plots aggregate dividends and share repurchases from 1971 through 2011 for all U.S. firms listed on U.S. stock exchanges (again, the figure uses a logarithmic vertical scale). A quick glance at the figure reveals that share repurchases played a relatively minor role in firms’ payout practices in the 1970s. In 1971, for example, aggregate dividends totaled $21 billion, but share repurchases that year were just $1.1 billion. In the 1980s, share repurchases began to grow rapidly and then slowed again in the early 1990s. The value of aggregate share repurchases first eclipsed total dividend payments in 1998. That year, firms paid $175 billion in dividends, but they repurchased $185 billion worth of stock. Share repurchases continued to outpace dividends for all but three of the next 13 years, peaking at $677 billion in 2007.

Whereas aggregate dividends rise smoothly over time, Figure 14.2 shows that share repurchases display much more volatility. The largest drops in repurchase activity occurred in 1974–1975, 1981, 1986, 1989–1991, 2000–2002, and 2008–2010. All these drops correspond to periods when the U.S. economy was mired in or just emerging from a recession. During most of these periods, dividends continued to grow modestly. Only during the recent, severe recession did both share repurchases and dividends fall.

FIGURE 14.2 Aggregate Dividends and Repurchases for All U.S.–Listed Companies

Aggregate U.S. dollar amount of dividends and share repurchases for all U.S. firms listed on U.S. stock exchanges in each year from 1971 through 2011 (the figure uses a logarithmic vertical scale)

in practice focus on ETHICS: Are Buybacks Really a Bargain?

When CBS announced in March 2007 that it would buy back $1.4 billion worth of stock, its sagging share price saw the biggest spike since the media giant parted ways with Viacom in 2005. The 4.5 percent jump may have been an omen of good fortune—at the very least, it showed how much shareholders like buybacks.

Companies have been gobbling up their own shares faster than ever in a world of inexpensive capital and swollen balance sheets. Since 2003, the market for buybacks has boomed, with repurchases nearly on a par with capital expenditures. Some, however, have questioned the moves and motives that lead to a big buyback.

In addition to simply returning cash to shareholders, many companies also repurchase stock because they believe that their stock is undervalued. New research, however, shows that companies often use creative financial reporting to push earnings downward before buybacks, making the stock seem undervalued and causing its price to bounce higher after the buyback. That pleases investors who then amplify the effect by pushing the price even higher.

“Managers who are acting opportunistically can use their reporting discretion to reduce the repurchase price by temporarily deflating earnings,” argue Guojin Gong, Henock Louis, and Amy Sun at Penn State University’s Smeal College of Business. Observing data from 1,720 companies, the authors say companies can easily create an apparent slump by speeding up or slowing down expense recognition, changing inventory accounting, or revising estimates of bad debt, all of which are classic methods of making the numbers look worse without actually breaking accounting rules.

The penalty for being caught deliberately managing earnings in advance of a buyback could be severe. With the variety of accounting scandals that popped up regularly in the early 2000s, executives would no doubt be wary of deflating earnings just to get a boost from a buyback. Still, that’s what Louis believes some are doing. “I don’t think what they’re doing is illegal,” he says. “But it’s misleading their investors.”

 Do you agree that corporate managers would manipulate their stock’s value prior to a buyback, or do you believe that corporations are more likely to initiate a buyback to enhance shareholder value?

Combining the lessons from Figures 14.1 and 14.2, we can draw three broad conclusions about firms’ payout policies. First, firms exhibit a strong desire to maintain modest, steady growth in dividends that is roughly consistent with the long-run growth in earnings. Second, share repurchases have accounted for a growing fraction of total cash payouts over time. Third, when earnings fluctuate, firms adjust their short-term payouts primarily by adjusting share repurchases (rather than dividends), cutting buybacks during recessions, and increasing them rapidly during economic expansions.

 Matter of fact

Share Repurchases Gain Worldwide Popularity

The growing importance of share repurchases in corporate payout policy is not confined to the United States. In most of the world’s largest economies, repurchases have been on the rise in recent years, eclipsing dividend payments at least some of the time in countries as diverse as Belgium, Denmark, Finland, Hungary, Ireland, Japan, Netherlands, South Korea, and Switzerland. A study of payout policy at firms from 25 different countries found that share repurchases rose at an annual rate of 19 percent from 1999 through 2008.


14–1What are the two ways that firms can distribute cash to shareholders?

14–2Why do rapidly growing firms generally pay no dividends?

14–3The dividend payout ratio equals dividends paid divided by earnings.

How would you expect this ratio to behave during a recession? What about during an economic boom?

14.2 The Mechanics of Payout Policy

LG 1

At quarterly or semiannual meetings, a firm’s board of directors decides whether and in what amount to pay cash dividends. If the firm has already established a precedent of paying dividends, the decision facing the board is usually whether to maintain or increase the dividend, and that decision is based primarily on the firm’s recent performance and its ability to generate cash flow in the future. Boards rarely cut dividends unless they believe that the firm’s ability to generate cash is in serious jeopardy. Figure 14.3 plots the number of U.S. public industrial firms that increased, decreased, or maintained their dividend payment in each year from 1981 through 2011. Clearly, the number of firms increasing their dividends is far greater than the number of companies cutting dividends in most years. When the economy is strong, as it was from 2003 to 2006, the ratio of industrial firms increasing dividends to those cutting dividends may be 10 to 1 or higher. However, a sign of the severity of the most recent recession was that in 2009 this ratio was just 1.5 to 1. That year, 401 U.S. public industrial firms increased their dividend, whereas 266 firms cut dividends.

FIGURE 14.3 U.S. Public Industrial Firms Increasing, Decreasing, or Maintaining Dividends

Number of U.S. public industrial firms that increased, decreased, or maintained their dividend payment in each year from 1981 through 2011

Figure 14.3 clearly shows that firms prefer to increase rather than decrease dividends, but what is most evident is that firms prefer to maintain their established dividend levels. In the average year, 79 percent of U.S. industrial firms elect to maintain their previous year’s dividend payout, and 96 percent avoid decreasing their dividend. Although some firms will choose to grow their dividend payout, the main goal of nearly all firms is to do whatever is necessary to avoid cutting dividends.


When a firm’s directors declare a dividend, they issue a statement indicating the dividend amount and setting three important dates: the date of record, the ex-dividend date, and the payment date. All persons whose names are recorded as stockholders on the date of record receive the dividend. These stockholders are often referred to as holders of record.

date of record (dividends)

Set by the firm’s directors, the date on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future time.

Because of the time needed to make bookkeeping entries when a stock is traded, the stock begins selling ex dividend 2 business days prior to the date of record. Purchasers of a stock selling ex dividend do not receive the current dividend. A simple way to determine the first day on which the stock sells ex dividend is to subtract 2 business days from the date of record.

ex dividend

A period beginning 2 business days prior to the date of record, during which a stock is sold without the right to receive the current dividend.

The payment date is the actual date on which the firm mails the dividend payment to the holders of record. It is generally a few weeks after the record date. An example will clarify the various dates and the accounting effects.

payment date

Set by the firm’s directors, the actual date on which the firm mails the dividend payment to the holders of record.

Example 14.1

On August 21, 2013, the board of directors of Best Buy announced that the firm’s next quarterly cash dividend would be $0.17 per share, payable on October 1, 2013, to shareholders of record on Tuesday, September 10, 2013. Best Buy shares would begin trading ex dividend on the previous Friday, September 6. At the time of the announcement, Best Buy had 340,967,179 shares of common stock outstanding, so the total dividend payment would be $57,964,420. Figure 14.4 shows a time line depicting the key dates relative to the Best Buy dividend. Before the dividend was declared, the key accounts of the firm were as follows (dollar values quoted in thousands):1

FIGURE 14.4 Dividend Payment Time Line

Time line for the announcement and payment of a cash dividend for Best Buy

Cash $680,000 Dividends payable $       0
    Retained earnings  3,395,000

When the dividend was announced by the directors, almost $58 million of the retained earnings ($0.17 per share × 341 million shares) was transferred to the dividends payable account. The key accounts thus became

Cash $680,000 Dividends payable $  57,964
    Retained earnings  3,337,036

When Best Buy actually paid the dividend on October 26, this produced the following balances in the key accounts of the firm:

Cash $622,036 Dividends payable $       0
    Retained earnings  3,337,036

The net effect of declaring and paying the dividend was to reduce the firm’s total assets (and stockholders’ equity) by almost $58 million.


1. The accounting transactions described here reflect only the effects of the dividend. Best Buy’s actual financial statements during this period obviously reflect many other transactions.

The mechanics of cash dividend payments are virtually the same for every dividend paid by every public company. With share repurchases, firms can use at least two different methods to get cash into the hands of shareholders. The most common method of executing a share repurchase program is called an open-market share repurchase. In an open-market share repurchase, as the name suggests, firms simply buy back some of their outstanding shares on the open market. Firms have a great deal of latitude regarding when and how they execute these open-market purchases. Some firms make purchases in fixed amounts at regular intervals, whereas other firms try to behave more opportunistically, buying back more shares when they think that the share price is relatively low and fewer shares when they think that the price is high.

open-market share repurchase

A share repurchase program in which firms simply buy back some of their outstanding shares on the open market.

In contrast, firms sometimes repurchase shares through a self-tender offer or simply a tender offer. In a tender offer share repurchase, a firm announces the price it is willing to pay to buy back shares and the quantity of shares it wishes to repurchase. The tender offer price is usually set at a significant premium above the current market price. Shareholders who want to participate let the firm know how many shares they would like to sell back to the firm at the stated price. If shareholders do not offer to sell back as many shares as the firm wants to repurchase, the firm may either cancel or extend the offer. If the offer is oversubscribed, meaning that shareholders want to sell more shares than the firms wants to repurchase, the firm typically repurchases shares on a pro rata basis. For example, if the firm wants to buy back 10 million shares, but 20 million shares are tendered by investors, the firm would repurchase exactly half of the shares tendered by each shareholder.

tender offer share repurchase

A repurchase program in which a firm offers to repurchase a fixed number of shares, usually at a premium relative to the market value, and shareholders decide whether or not they want to sell back their shares at that price.

A third method of buying back shares is called a Dutch auction share repurchase. In a Dutch auction, the firm specifies a range of prices at which it is willing to repurchase shares and the quantity of shares that it desires. Investors can tender their shares to the firm at any price in the specified range, which allows the firm to trace out a demand curve for their stock. That is, the demand curve specifies how many shares investors will sell back to the firm at each price in the offer range. This analysis allows the firm to determine the minimum price required to repurchase the desired quantity of shares, and every shareholder receives that price.

Dutch auction share repurchase

A repurchase method in which the firm specifies how many shares it wants to buy back and a range of prices at which it is willing to repurchase shares. Investors specify how many shares they will sell at each price in the range, and the firm determines the minimum price required to repurchase its target number of shares. All investors who tender receive the same price.

Example 14.2

In July 2013, Fidelity National Information Services announced a Dutch auction repurchase for 86 million common shares at prices ranging from $29 to $31.50 per share. Fidelity shareholders were instructed to contact the company to indicate how many shares they would be willing to sell at different prices in this range. Suppose that after accumulating this information from investors, Fidelity constructed the following demand schedule:

Offer price Shares tendered Cumulative total
$29  5,000,000   5,000,000
 29.25 10,000,000  15,000,000
 29.50 15,000,000  30,000,000
 29.75 18,000,000  48,000,000
 30 18,500,000  66,500,000
 31.25 19,500,000  86,000,000
 31.50 20,000,000 106,000,000

At a price of $31.25, shareholders are willing to tender a total of 86 million shares, exactly the amount that Fidelity wants to repurchase. Each shareholder who expressed a willingness to tender their shares at a price of $31.25 or less receives $31.25, and Fidelity repurchases all 86 million shares at a cost of roughly $2.7 billion.