Date posted: 07/04/2017 3 min read

Why businesses are paying higher dividends

If projects providing a healthy return cannot be found, businesses will opt to instead pay large dividends to their shareholders.

In brief

  • In 2016-17 Australian businesses paid A$72b in dividends.
  • Commodity prices and the lack of investment opportunities are keeping shareholders cashed up.
  • In 2016-17 Australian businesses reported their largest earnings since 2001 with mining industry profits well ahead.

By Lee Smales.  

Typically, low interest rates, together with record profits, would create an environment in which businesses would be happy to invest in new projects – providing a boost to economic growth and jobs.

Unfortunately, we do not appear to be living in “typical” times. Rather than lifting investment, businesses have chosen to return cash to shareholders in the form of record dividends and share buybacks.

There are many possible reasons – including political uncertainty – why businesses are seemingly ignoring the supportive economic environment and paying such large dividends (A$72b in 2016-17) instead of reinvesting in growth opportunities.  

Three likely candidates are firm commitments to set dividend payouts, the sustainability of current commodity prices and a perceived lack of investment opportunities.  

This is not necessarily bad for the economy. Private investors will be happy to have more cash in their pockets and at least some of the extra cash handed to shareholders will result in increased consumption, which may encourage businesses to invest in the future.  

Three key reasons

Having come to the end of a major investment cycle, many resources companies are reluctant, for example, to build more mines and create more supply as this creates downward pressure on prices. These companies have committed to a set dividend payout ratio. Mining giant BHP Billiton, for example, promises to pay its shareholders at least 50% of underlying profits.

Mining giant BHP Billiton promises to pay its shareholders at least 50% of underlying profits.

The high level of dividends in the mining sector says something about the sustainability of current commodity prices. Despite extra supply from a number of additional mines (and increased production from existing mines) being available in 2016, the iron ore price has surged to more than US$90 per tonne.  

However, for mining companies to justify investing the billions of dollars required for a new mine, they need to have some comfort that such prices will persist. While the majority of forecasters have revised up their estimates, the consensus is still for the price to fall below US$60 per tonne by 2018.  

The third reason is a perceived lack of investment opportunities. One explanation for this may be a reduction in infrastructure spending by state and federal governments owing to fiscal constraints.

If businesses cannot identify a project that provides an adequate return on capital, then they are better off returning cash to shareholders. Corporate finance theory would suggest this is good.  

What about political uncertainty?

Perhaps the largest drag on investment results from the high level of uncertainty about the geopolitical environment. Domestically there appears to be little policy direction from a Coalition government wary of a rise in populism.  

Regionally, Reserve Bank Governor Philip Lowe has identified possible risks in China owing to a continued build-up of debt. And globally, the Trump administration in the US is perhaps the biggest cause of uncertainty.  

In the months since Donald Trump’s victory in the US presidential election, global share markets have rallied strongly. Australia’s market has been no different.  

The All Ordinaries index has risen by 10% in the past quarter. However, the key to maintaining high prices is earnings growth.

The February earnings season did not disappoint in this respect. For the last quarter of 2016, Australian businesses reported their biggest earnings increase since 2001 – well ahead of market expectations.  

The strong results have largely been driven by a 21% (A$4b) surge in mining industry profits. Thanks to a dramatic increase in commodity prices, tighter cost controls and increased efficiencies, the industry reported gross profits (trend estimate) of more than A$24b for the quarter.  

Across the board, firm profitability has benefited from below-trend growth in wages. Deregulation, infrastructure investment and tax reform could boost global growth and encourage investment by Australian firms in the process. However, negatives resulting from the potential for trade war – or worse, owing to the redrawing of US foreign policy – will clearly hold back investment.  

My research has shown that political uncertainty is ultimately a negative for share markets. Frictions in the investment decision process act as one mechanism for this relationship. In the meantime, shareholders should enjoy the benefit of higher dividend payouts while they last.  

Lee Smales is associate professor of finance in the Graduate School of Business at Curtin University. This piece first appeared on The Conversation.