This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The principle of greatest practical importance is that regularity in the dividend rate is highly desirable. This principle must be regarded as almost a discovery of the last generation or two. Formerly the unquestioned practice was to regard shareholders as standing in substantially the same relation as partners. They were supposed to be familiar with the status and fluctuations of the business and were expected to share in its ups and downs. If the enterprise enjoyed an exceptionally good year, it was accepted as a matter of course that the dividend rate would be correspondingly increased. If in the following year there was a sharp decline in profits, the dividend rate should be correspondingly cut. As a matter of fact, this is today the practice of a great number - perhaps the majority - of corporations. In so far as it is followed by close corporations, all the stock of which is held by men who are themselves active in the business and familiar with its every phase, it is probably unobjectionable. It is a matter of personal preference in many cases, and has the advantage of stimulating the interest of those shareholders who are active in the business to the highest degree.
But the corporation which has shareholders who are not active in the business or familiar with it is in a different situation. This remark applies with especial force to the great corporations that number their shareholders in the thousands or tens of thousands. The great majority of the shareholders of such corporations have only the barest information as to the manner in which the business is handled and as to the results that are being achieved, and are not sufficiently familiar with the business or sufficiently interested in it to absorb more detailed information if it were given to them. They regard their ownership of a company's stock purely as an investment of capital that will bring them an income. They buy a railroad or an industrial stock with much the same purpose as they would have in buying a real estate mortgage - the only purpose being that of securing a dependable income with a chance at profits. The object that is actually in their minds in making the purchase is not a partnership interest in a going enterprise, but certain pieces of paper called "certificates of stock" which at regular intervals will bring them dividend checks.
To shareholders of this type regularity in their dividend returns is of the highest importance. They count upon these returns as a fixed portion of their income - indeed, in thousands of instances the living expenses of dependents are provided out of these dividends. Approximately half the stockholders of the New Haven Railroad are women. The effort of the directors of a corporation which includes a large proportion of shareholders of this type should clearly be to meet their needs by paying a permanent rate of dividends with the fewest possible fluctuations. This rate of dividends in a really stable and conservatively managed corporation never varies except when it is increased. And it is not increased until after the directors have assured themselves that in all human probability a later decrease will not become necessary. If there are unusual, or possibly temporary, profits which it is thought wise to distribute, the directors of such corporations will ordinarily announce an "extra" dividend or once in a while will cut a "melon" in the form of a stock dividend or a subscription privilege. These extras, however, are to be regarded only as incidents which should not be allowed to disturb the regular and uninterrupted flow of dividends.
The desirability of maintaining regularity of dividend rates rests not merely upon the duty of the corporation to its share• holders, but also upon a substantial gain for the corporation itself. By reason of the fact that shares which yield regular dividends are in demand by so large a body of owners of capital who are not engaged in active business, there is a much stronger demand for these shares than for those which are paying irregular dividends. Out of two issues of common stock otherwise equivalent, one of which is paying a permanent dividend rate year after year and the other of which is paying dividends irregularly but averaging at least as high as the regular payer, the first-named issue will always sell at a substantially higher price. For this reason, the corporation which has succeeded over a period of years in maintaining a record of dividend stability, and which has not changed and is not likely to change its dividend except to raise it to a permanently higher level, enjoys the benefit of a credit and of a demand for its securities which is worth a large amount of money.
For both these reasons, even the smaller corporations are tending more and more strongly toward so adjusting their affairs that regularity - or at least approximate regularity - of their dividend rates can be attained. It is coming to be more and more widely recognized by bankers, investors, and the public at large, that the ability of a company to maintain regular rates is a better test of its soundness than is its ability to pay high but irregular dividends.