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.
There is obviously only one satisfactory answer - dividends must not be allowed to rise, even in the most prosperous periods, above a conservative estimate of the minimum earnings of the company. Those concerns which suffer from great fluctuations find this to be a harsh rule. It means that, so long as there remains even a reasonable possibility that earnings may sink close to or below the level of fixed and contingent charges, no dividends whatever should be paid. This has, in fact, been the rule followed by all really successful corporations the nature of the business of which involves unavoidable fluctuations. The Carnegie Steel Company ran as a highly successful corporation for many years without paying dividends. When Charles M. Schwab took control of the Bethlehem Steel Corporation in 1902 and started to build it up, it was on the basis of devoting all the earnings to upbuilding without paying a cent of dividends - and the policy has since been rigorously followed. Even after a corporation of this nature begins to pay dividends, it is not to be expected, if the management is conservative, that they will rise anywhere near the level of the average earnings. The rule of keeping dividend payments below the level of minimum earnings must strictly be adhered to.
Possibly the net result may, at first glance, seem to be a permanent loss to the shareholder, who can never expect on this principle to receive in dividends any large proportion of the actual earnings of their corporation. However, this loss is apparent, not real, for two reasons:
1. The proportion of earnings paid out in dividends being small, there is a rapid increase in the productive capacity of the company, due to betterments provided out of surplus, and this increase may in the course of a few years raise even the minimum net earnings far above the average earnings that would otherwise have been received.
2. The very fact that lines of business in which great fluctuations occur call for extreme patience and self-denial on the part of shareholders, means that comparatively few men are willing to put their capital and energy into getting a business of this nature thoroughly well established and that opportunities for exceptionally large profits are, for this reason, left open.
It is partly owing to this condition that Andrew Carnegie and his partners built up their wonderfully profitable iron and steel business. Their earnings year after year went back into the business, and they did not themselves realize the full value of the property they had created. But when the time arrived for the formation of the United States Steel Corporation, the market value of the securities that went to the Carnegie Company was well over $500,000,000. The same rule could be applied with even less question and more rigor to those corporations which conduct a comparatively stable business. For them it is only a minor hardship to keep dividend payments below the level of minimum earnings. This regularity of dividend payments results in a gain in credit that is secured with relatively little sacrifice.