The research paper provides an analysis and critique of several literature materials on dividend policy in Saudi firms majorly focusing on non-financial firms. In Saudi Arabia, dividend policy is an imperative tool because most companies receive nearly 100 percent of their earnings in dividends. In terms of such an economy, firms are majorly funded by bank loans and therefore, there exist no taxes on capital or income gains. Some of the most identifiable factors influencing the dividend policy of both non-financial and financial companies in Saudi Arabia are discussed in the current paper. The current paper is a report, which helps understand the strategic financial policies in regard to the real-life, specifically dividends policy in Saudi Arabia.
Dividend policy is a major financial decision that a company has to make for the shareholders to be rewarded for their investment in the business. It is one of the most predictable and stable elements of a firm. Most firms commence dividend payments when the firm matures because, during such a period, the firm obtains fewer opportunities to invest in some business in order to raise the capital. It is therefore imperative for the management of the company to accurately predict whether the dividends are to be raised or lowered for the purpose of sustainability. The dividend policy is a necessity of the policy formulators, managers, stakeholders, investors, and loaners. It enables the investors to ensure the ability of the business to pay dividends on their invested funds. The dividend policy is well-defined and increases the financial stability of any given company.
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The dividend policy report evaluates the interest of the manager of a firm to assist them in making sound financial decisions that can gear the firm towards achieving positive growth in terms of investment opportunities. The report further justifies why a well-informed understanding of the dividend policy as a financial strategy can be applied by the manager in real life, especially in Saudi Arabia where my company operates. Saudi Arabia is a member of the OPEC being responsible for nearly 28 percent of total petroleum production. It is also an active member of the Gulf Cooperation Council (GCC) contributing nearly 57 percent of its total petroleum production. Moreover, it is the world’s greatest producer and exporter of petroleum.
3.0. Theoretical Basis
It is important to start the research by examining the dividend theories before focusing on the dividend policy of Saudi firms. According to Alzomaia and Al-Khadhiri (2013, p.181) and Malkawi, Twairesh, and Harry (2013, p. 518), the dividend policy does not determine a firm’s share price. The authors further cite the Modigliani and Miller theory that has been developed for the global market that is perfectly efficient and suggests that a company is earning power, while the risks incurred affect its value. According to this theory, it is assumed that there is no taxation on businesses and the firms do not incur any transaction costs. However, most financial studies disagree with this proposition that makes assumptions on the perfect capital market. Al-Haddad et al. (2011, p. 201) note that in an attempt to provide alternatives to the theory, researchers have come up with competing hypotheses and theories that illustrate empirical evidence on the issue of dividends in an imperfect capital market. One such theory is the dividends preference theory that indicates that investors prefer dividends to retained earnings. The theory argues that as dividends increase, the stock risk price reduces. It means that dividends are a form of returns being guaranteed as opposed to capital gains, which are a form of risky return. Firms should, therefore, ensure a wide margin of dividend payout ratio so as to optimize its share price.
Alzomaia and Al-Khadhiri (2013, p. 182) further argue that the tax preference theory that has been introduced in the 1970s highlights that there is a preference for companies with lower payout by the investors for tax reasons. It is because the investor can postpone payment of tax until the stock is sold to enable them to enjoy long-term capital benefits. A tax that is remitted immediately has a greater value of effective capital cost compared to deferred tax due to the effects of time value. Another theory is the dividends signaling theory, which suggests that the changes in dividend payment convey a signal to the investors concerning the earnings of the company in the future and the perception of dividends by the management. It highlights that the managers of a company cannot raise the dividends until they are sure about the future earnings of the firm. In a situation where the company reduces dividends, dividend cuts are considered by the investors as a bad signal regarding future earnings. Later on, the residual and transactional cost theory was introduced. The theory highlights that the company will pay high costs for transactions in case the external finance source is required. It implies that in order to avoid such costs, the company has to reduce its dividends. The theory was succeeded by an agency cost theory that introduced an assumption that companies having low dividends payout are not as valuable as companies with high dividends payout. The argument of the theory is focused on the assumption that the investors will avert the payment of agency costs aimed at monitoring the actions of the management in terms of unfitting behaviors.
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There are determinants of the dividends policy for the companies that are listed in the stock exchange such as the Gulf Cooperation Council (GCC) stock exchange, whose member is Saudi Arabia among others (Malkawi, Twairesh, & Harery 2013, p. 518). Another research was conducted using Tobit models for the countries listed in the GCC states stock exchange. It was observed that companies, where the government-owned a proportion of the total shares, paid higher dividends to the shareholders compared to the companies that were entirely owned by private investors. According to the model, high dividends rate results in a high rate of profitability and the leverage ratio influence the dividend payout ratio.
3.1. Stock Overview of Saudi Stock Market
3.1.1. The Initial Period between 1930 and 2003
According to Alzomaia and Al-Khadhiri (2013 p. 184), Saudi joint-stock firms were founded in the 1930s during the establishment of the Arab Automobile firm as the first joint-stock company. The Saudi stock market had been crude and non-formal for a long time due to its economic orientation of developing infrastructure and human resources aimed at improving the economic life of the citizens. As a result, minimal effort was made to develop the Saudi stock market. A tremendous and steady economic expansion in Saudi Arabia led to the establishment of several joint-stock banks and big corporations. Until the 1980s, the Saudi stock market remained informal, but afterward, the government began to modernize and regulate it with the aim of ensuring efficiency and safety in the stock market.
As a result, the government implemented the required systems that could guarantee safety and efficiency. The Saudi Arabian Monetary Agency (SAMA) was instituted in 1984 with a mandate of developing and regulating the stock market. At that particular time, the Saudi Share Registration Company (SSRC) was established by 12 commercial banks with the aim of creating a centralized registration facility for Saudi joint-stock companies. SSRC was mandated to clear and settle all transactions that involved shares. Later on, in 1990, SAMA introduced an electronic share information system (ESIS). The aim of this electronic system was to focus all equity trading that involved multi-location trading into a single market that would be floorless.
3.1.2. The Current Restructured State of the Stock Market of Saudi Arabia
The Capital Market Authority (CMA) of the Saudi companies was created in 2003 under the Capital Market Laws (CML) according to the royal decree (Alzomaia & Khadhiri 2013, p. 184) with an objective of monitoring and governing the Saudi stock market. It is thus, oriented towards protecting the shareholders and guaranteeing efficacy in trading of shares and equity in the stock exchange market. It is an autonomous government agency, which the prime minister is responsible for. Due to this, it has a full mandate to modulate and enforce all the fundamental legal thresholds of the stock market.
However, the mandate of the CMA is not just restricted to monitoring and supervising the payers in the capital market. It has invented various ways through which it can boost awareness and develop an investment culture among the citizens and foreigners with the aim of guarding them against the risks associated with the capital market. Since then, there have been remarkable milestones in the Saudi stock market. A good example is the Saudi Stock Exchange (SSE) established in 2007 with the objective of solely conducting financial security trade. The CMA carried out a massive restructuring of the Saudi stock market in 2008. The Saudi Arabian Stock Exchangers (TASI) and the indices of the new economic sectors were computed based on the free-floating and actual shares that could be traded. The intermediary services in the stock market are currently offered by the CMA starting from 2009. This step is a relief to the commercial banks. It has resulted in increased competition among the members that trade their shares at the stock market.
3.2. Empirical Computation of Dividends
In order to explain the correlation between the dividends per share realized by the company in Saudi Arabia and the variables such as the previous dividends, the earnings per share and other components of shares, a regression analysis is required. Below is a summary of the regression analysis equation that represents the following relationship:
Dividends per Share (DPS): is the number of dividends that are payable to the stockholders relative to a firm’s total number of shares issued. The figure depicts the unbiased company earnings in regard to the dividends payout ratio.
Earnings per Share (EPS): is the amount of money that the stock of a company earns per an outstanding share. It is computed by the net profit in terms of the outstanding shares. This figure affects the dividend level of the company (Al Masum 2014, p. 12).
Previous Dividends per Share ratio: is a firm’s dividend per share for the previous year.
Growth ratio: is a ratio of the sales of the current financial year and the sales realized during the previous year, which are less than the sales achieved in the previous financial year.
Debt equity ratio/ capital structure: It is a ratio of the business’ overall long-term debt and the total equity. It is negatively related to the dividends and this implies that when it is low, the firm is likely to pay increased dividends to the investors.
Capital size: dividend policy can be explained better using the size of the company. Established companies have easier access to the capital market since they have attained maturity. The implication is that they can pay more dividends to the shareholders.
Market Risk: it shows the correlation between the price return of a firm and the overall financial market.
The table 1 below shows the performance of the Saudi Stock Exchange in regard to dividends paid from 2004 to 2010.
Figure 1. The progress of Dividends in the Stock Exchange market from 2004 to 2010 Source: Alzomaia and Khadhiri (2013, p. 186)
Figure 2. The Saudi Stock Market New Market Sector Source: Alzomaia and Khadhiri (2013, p. 184)
Table 2 above shows the new market sector entry into the SSE.
Table 3 below shows the history of the growth of the stock market in Saudi Arabia.
Figure 3. Saudi Stock Market History of Growth Source: Alzomaia and Khadhiri (2013 p.185)
Figure 4. The Payout Ratio for Saudi Stock Market Source: Alzomaia and Khadhiri (2013, p. 186)
Figure 4 above shows the payout ratio for the Saudi Stock Market.
3.3. Factors Influencing Corporate Dividend Policy
The dividend policy of a company can be affected by different factors as discussed below.
The profitability of a given firm is one of the most significant determinants when making decisions on dividend policy. Dividends are the distribution of the profits paid by a firm to the shareholders. The companies that are profitable have more chances of paying dividends to its shareholders as opposed to less-profitable or non-profitable firms. The most mature firms finance their investments using retained earnings as a source of internally generated funds. In the case where there is a need for external funding, such firms give preference to debts instead of equity. As a result, information asymmetry costs are reduced together with other costs of the transaction. Such a financing hierarchy has a significant influence on the decisions made concerning dividends.
Ceteris paribus, firms that are less profitable cannot pay dividends to the investors considering equity financing and cost when issuing the debt. The relationship that exists between dividends and profitability can be explained using the pecking order hypothesis. In the case of the emerging markets such as Saudi and Amman stock exchange markets, profitability is the major determinant of dividends payment level and the likelihood of paying the dividends to the shareholders. Saudi Arabia, in particular, depicts a positive correlation between the likelihood of paying dividends to the investors and the firms’ profitability that can be measured by examining the earnings per share (Alzomaia & Khadhiri 2013, p.519). In order to measure profitability, a tool called Return on Equity (ROE) is employed. ROE is a financial policy tool that can be used in the case of Saudi Arabia to increase the likelihood of dividends paid.
3.3.2. Earnings Variability
Firms that have stable earnings can use dividend signaling hypothesis to predict the future dividend earnings with utmost accuracy (Aivazian, Booth, & Cleary 2003, p. 380; Malkawi, Twairesh, & Harery 2013, p.519). It is possible for such firms to pay huge percentages of their earnings to the shareholders as dividends with reduced risk of dividend will be cut in the future. In other words, there exists an inverse relationship between dividend payout and earnings variability. In the case of the Canadian firms that pay dividends to the shareholders, stability in earnings is perceived as the most important factor that determines the dividend policy. In order to extenuate the agency problem that exists between managers and owners, the agency theory should be used to predict the payment of dividends (Al-Kuwari 2010, p. 21). High payout ratios can result in increased transaction costs in the case where the firm has been externally funded. It implies that firms that experience increased business risks should pay reduced dividends to their investors. Studies by Aivazian, Booth, and Cleary (2003, p. 380) showed that there is a negative correlation between dividends payouts and business risks. Thus, a business risk decreases the probability of paying out dividends to the shareholder’s ceteris paribus.
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3.3.3. Firm Size
Corporate dividend policy decisions can be greatly affected by the size of a firm. Larger companies have increased access to capital markets. As a result, it is easier for them to generate capital funds with fewer constraints and lower costs in comparison to smaller companies. It implies that when other factors are kept constant, big business corporations do not rely much on funds that are generated internally. Therefore, such businesses have the capacity to pay higher rates of dividends to their investors compared to smaller ones. The best way to understand this is to consider the consistency between the dividend policy and transaction costs. Furthermore, big companies demonstrate an increased information asymmetry level with increased agency costs. Such companies should, therefore, pay higher rates of dividends to the investors in order to mitigate agency costs. In order to regulate equity agency costs, the management of big companies has to use less ownership as a result of liquidity costs. Instead, they have to increase the utilization of dividends due to minimal floatation costs.
In the context of Saudi Arabia, there is an undistinguished correlation between the size of the business and the payment of dividends to the investors. On the contrary, there is a substantial correlation between the size of the business and the likelihood of the dividends being paid to the investors. In the case of the emerging markets, the size of the business or risks incurred does not determine the dividends policy substantially. In other words, there is a positive relationship between the size of the business and the likelihood of dividends payment to the investors. Therefore, large business corporations are more likely to pay dividends in comparison to small ones.
When a company obtains debt funding, it has an obligation of meeting the resultant fixed financial charges that accrue as a result of the principal amount and interest payment. If such a company does not meet the required obligations, it may undergo liquidation. The risks that result from a high level of financial leverage may lead to reduced rates of dividends paid. It is because ceteris paribus companies must sustain their internal cash flow to enable them to meet their financial obligations instead of paying dividends to the shareholders. It, therefore, means that the companies with high financial leverage exhibit reduced dividend payouts to the investors so as to minimize the costs of transactions that accrue as a result of external financing. The interpretation is that ordinarily, there is a negative relationship between dividends and leverage.
Companies that exhibit more investment opportunities and a high rate of growth require more funding to be internally generated in order to finance such investments. It implies that such firms will pay out lower rates of dividends or sometimes none at all. Such a relationship can be best explained using the pecking order hypothesis. On the other hand, signaling theory and residual theory offer an explanation of the kind of relationship that exists between external funding and the rate of dividends paid to the shareholders. In the case of residual theory, firms that have more opportunities for growth generally pay lower rates of dividends to their shareholders. The reason lies in the fact that it is possible for them to finance their investments using the available finances and in the end, register positive net present values. Similarly, in the case of signaling theory, high dividends payout to shareholders can be associated with increased investment opportunities. The reason for this is that firms that operate on a higher quality scale usually pay out higher rates of dividends to their shareholders as a way of making the market aware of their quality. Such a decision is meant to attract more investors to the firm in order to increase their capital base.
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In addition, the transaction costs hypothesis highlights that there is a negative correlation between dividends payouts to the respective shareholders and the growth of a company. In other words, companies that experience increased growth require additional internal funding so as to mitigate the transaction costs that accrue as a result of external funding. It means that there is a significant negative correlation between the investment opportunities of any company and the dividends payout to the shareholders. It is therefore worth concluding that corporate dividend policy is greatly determined by the company’s investment opportunities. Companies that portray steady and increased growth trends and better investment opportunities are faced with a lower dividend payout to the shareholders. Such an inverse relationship can be explained better with the help of a proxy for growth opportunities that divides the actual equity value according to the book equity value and normalizes the results according to the number of outstanding shares (Aivazian, Booth, & Cleary 2006 p. 442). The result is that the likelihood of the dividends to be paid by the company to the shareholders is decreased by the growth achieved by the company if other factors are kept constant.
3.3.6. Ownership Structure
The ownership structure of a company plays a significant role when it comes to monitoring the company’s managers in states that have low minority shareholders protection level and those that exhibit feeble corporate governance (Osman & Mohammed 2010, p.102). As a result, such companies have reduced agency costs, and this implies that there is less reliance on the company’s dividends. It means that such companies do not rely on dividends payout as a mechanism of minimizing agency costs.
3.3.7. Government Shareholdings
The agencies of the government usually control and own many big companies that are publicly traded among several nations globally, for instance, in Saudi Arabia. In such a scenario, dividend policy is greatly influenced wherever the largest shareholder of a company is the government or the relevant state agencies. Similarly, in the case of state-controlled companies, the government undertakes transactions on behalf of its citizens. The citizens are not in direct control of the company’s shares, yet they are their ultimate owners. The result of such a situation is a double principal conflict. This means that agency problems may arise between the government representatives and the citizens. The problem is that the representatives of the government may not work for the best interests of the citizens (Inyiama, Okwo, & Inyiama 2015, p. 104). On the other hand, agency problems may be experienced between the management and the state-owner. In addition, the financial strength of a business may reduce as a result of dividends payment, and this may help mitigate agency problems.
The interpretation of such a scenario is that there exists a positive correlation between state ownership of a corporation and dividends payout to the investors. As a rule, it means that state-governed businesses pay higher rates of dividends. The likelihood of paying dividends by firms increases with state shareholding. In the context of Saudi Arabia, there is no association between the dividend policy and state ownership of corporations in terms of the capital share investments.
3.3.8. Institutional Shareholdings
Institutional shareholders contribute significantly to the company’s ownership structure by supervising the corporate managers, and it results in reduced agency costs. The role of monitoring of the managers by the institutional shareholders is actuated by the economies of scale that result from their considerable shareholding. In addition, such a monitoring role becomes relatively more effective. Furthermore, institutional investors are better placed to absorb inefficient firms compared to small investors, and this may raise the efficiency of the managers. Small investors attract high dividends payout to the shareholders so as to compensate and attract more affluent shareholders. Attracting affluent shareholders enables them to efficiently execute the role of management monitoring. Institutional or corporate investors are easily attracted to stocks that yield high dividends. In other words, institutional shareholders have a high probability of investing in stocks that pay dividends for fiduciary and tax reasons. A number of portfolio managers reckon that is it better to invest in stocks that do not pay dividends. It means that there is a connection between the dividend payout to the shareholders and institutional ownership of businesses. Therefore, the likelihood of the dividends to be paid to the investors by a business is increased as the institutional shareholding increases.
3.3.9. Family Shareholdings
In family-owned companies, the conflict between the manager and the shareholder is greatly reduced due to the fact that the ultimate shareowners and the managers eventually happen to be the same entities. The family members are the largest shareholders that tend to have strong incentives with the capacity to execute the role of monitoring over the management of the company. Because of this, dividends as a mechanism of lowering the information asymmetry and agency costs between the owners and the managers are of lower value. It, therefore, implies that the companies that are controlled and owned by families do not have high dividend payout ratios. However, there is a probability that the agency problems will occur between the family shareholders who are actually the major shareholders and the non-family shareholders. It is worth noting that the likelihood of a company to pay dividends to the shareholders is decreased by family shareholding or ownership.
3.3.10. Asset Structure
Generally, the assets owned by a company are categorized into two groups, namely: long-term assets (fixed) and short-term assets (current). Fixed assets can either be intangible or tangible. The tangible assets of the company can act as collateral for securing long-term external or debt funding. If other factors are kept constant, the debt capacity of a company is increased with the help of the increased level of tangibility. It implies that the company relies less on its retained earnings, and this ensures that the company will have extra funds to be paid to the shareholders as dividends. In other words, there exists a positive correlation between the dividends payout to the shareholders and the tangibility of the company’s assets. However, the companies that operate in emerging stock markets experience a negative correlation between the two variables. Such a scenario can be attributed to the uniqueness of the financial system that countries with emerging stock markets have. The emerging stock markets are known for the prevalence of short-term bank funds. Since the financial market of such nations is dominated by short-term bank debts, an increase in asset tangibility is likely to result in the reduced short-term borrowing ability of companies within such stock markets. In other words, a great proportion of long-term tangible assets will lead to a reduced percentage of short-term assets that can be used for short-term bank funding as collateral. Therefore, the likelihood of a company to pay dividends to the shareholders is decreased by the tangibility of the assets of the firm if other factors are kept constant. In the Saudi Arabian context, the negative correlation between the tangibility of assets and dividends does not take place.
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3.3.11. The Age of the Firm
From a general perspective, mature companies have a high possibility of experiencing a phase of low-growth with minimal investment opportunities. The reason for this is that a mature company does not have the incentives necessary for establishing the accumulation of reserves since they are relatively older. As a result, they experience reduced capital expenditure and a lower rate of growth. Consequently, they can adopt a dividend policy that is liberal. On the other hand, new and emerging companies require the accumulation of reserves in order to cope with the emerging financial requirements necessary for achieving rapid growth. Therefore, such companies retain most of their earnings and payout low-rate or no dividends to their shareholders. If other factors are held constant, investment opportunities will decrease as the company matures. The result would be reduced growth rates. Such a scenario leads to reduced funds requirements for the purposes of capital expenditure by a company. In other words, there exists a positive correlation between the age of a company and the rate of dividend payout to the respective shareholders of the company. Thus, the likelihood of a company to pay dividends to its shareholders increases with the age of a company or its maturity.
As is evident from many stock markets, the inverse relationship that exists between tangibility assets and the dividends payout does not apply when considering the influence of asset structure on the dividend policy. Another similar scenario is seen in regard to the government shareholding in many large firms. It also means that the dividend policy of Saudi Arabia is not determined by the government ownership of large companies. Considering the size of businesses or corporations in Saudi Arabia, there is no substantial relationship between dividends policy and their sizes. However, among Saudi firms, profitability is the major determinant of the dividend policy. It implies that together with the increase of profitability of a Saudi firm, the possibility that the dividends will be paid to the respective shareholders’ increases.