We began this chapter by expanding our definition of cash returned to stockholder to include stock buybacks with dividends. Firms in the United States, especially, have turned to buying back stock and returning cash selectively to those investors who need it.

With this expanded definition of cash returned to stockholders, we first used a cash flow based approach to decide whether a firm is paying too much or too little to its stockholders. To form this judgment, we first estimate what the firm has available to pay out to its stockholders; we measure this cash flow by looking at the cash left over after reinvestment needs have been and debt has been serviced, and call it the free cash flow to equity. We then look at the quality of the firm's projects; firms with better projects get more leeway from equity investors to accumulate cash than firms with poor projects. We next consider the effect of wanting to increase or decrease the debt ratio on how much cash is returned to stockholders. Finally, we consider all three factors - the cash flow available for stockholders, the returns on existing investments and the need to increase or decrease debt ratios - in coming up with broad conclusions about dividend policy. Firms with a good track record in investing can pay out less in dividends than is available in cash flows, and not face significant pressure from stockholders to pay out more. When the managers of firms are not trusted by their stockholders to invest wisely, firms are much more likely to face pressure to return excess cash to stockholders.

We also analyzed a firm's dividend policy by looking at the dividend policies of comparable firms in the business. In this approach, a firm that is paying out less in dividends than comparable firms would be viewed as paying too little and one that is paying out more would be viewed as paying too much. We use both a narrow definition of comparable firms (firms in the same line of business), and a broader definition (all firms). We control for differences in risk and growth across firms, using a multiple regression.

We closed the chapter by looking at how firms that intend to change their dividend policy can minimize the side-costs of doing so. This is especially true when firms have to reduce their dividends to meet legitimate reinvestment needs. While the initial reaction to the announcement of a dividend cut is likely to be negative, firms can buffer some of the impact by providing information to markets about the investments that they plan to accept with the funds.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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