The Lintner model is a formula designed to help companies determine an optimal corporate dividend policy. Introduced by former Harvard Business School professor John Lintner in 1956, the model emphasizes two key components:
- A company’s target payout ratio.
- The speed at which current dividends adjust to reach this target.
While John Lintner initially intended the model to descriptively explain how firms set dividends, today it also serves a prescriptive purpose, illustrating how firms should ideally set their dividend policies.
Key Takeaways
- The Lintner Model is an economic formula for establishing a firm’s optimal dividend policy.
- The model emphasizes the target dividend payout ratio and the stability of increased dividends over time.
- It enables a company’s board of directors to assess the effectiveness of their dividend policy easily.
Grasping the Concept of the Lintner Model
To depict a mature corporation’s dividend payout, the Lintner Model can be summarized by the following formula:
D_t = k + PAC(TD_t - D_{t-1}) + e_t
where:
D = Dividend
D_t = Dividend at time t
PAC = Partial adjustment coefficient (PAC < 1)
TD = Target Dividend
k = Constant
e_t = Error term
John Lintner formulated this model in 1956 through his inductive research involving 28 major public manufacturing firms. Although Lintner has since passed away, his model remains a cornerstone for understanding corporate dividend behavior.
Lintner’s research unveiled several key facets of corporate dividend policies:
- Companies set long-term target dividends-to-earnings ratios based on the number of positive net present value (NPV) projects they have.
- Increase in earnings isn’t always sustainable. Therefore, dividend policies seldom alter significantly until managers confirm the new earnings’ sustainability.
Though companies aim to maintain a consistent dividend payout to maximize shareholder value, natural business fluctuations necessitate projecting dividends based on long-term target payout ratios.
This model advises a company’s board of directors to base their dividend decisions on the firm’s present net income, yet gradually adapt to shifts in income over time, accounting for systemic shocks.
The Application of the Lintner Model in Setting Corporate Dividends
A company’s board of directors determines the dividend policy, including the payout rate and distribution dates. Unlike other critical corporate measures, such as mergers or executive compensation, shareholders cannot vote on this policy.
Companies generally follow one of three main approaches to corporate dividend policy:
- Residual Approach: Dividend payments are made from leftover equity after fulfilling specific project capital needs. Firms using this strategy aim to balance their debt-to-equity (D/E) ratios before distributing dividends.
- Stability Approach: Here, dividends are set as a fraction of yearly earnings, typically paid out on a quarterly basis. This approach minimizes investor uncertainty and ensures a steady income stream.
- Hybrid Approach: Combining elements of the residual and stability approaches, the board targets a longer-term debt-to-equity ratio. In such cases, companies set a small, consistent dividend alongside an extra dividend payment during years of higher income.
Understanding and utilizing the Lintner Model can provide invaluable insights for firms aiming to balance dividend consistency with the flexibility needed to adapt to financial variability.
Related Terms: dividend payout ratio, net present value, board of directors, dividends, earnings.
References
- Harvard Business School. “John V. Lintner Papers: Finding Aid”.
- Lintner, John. “Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes”. The American Economic Review, vol. 46, no 2, 1956, pp. 97-113.
- Raju, Guntur Anjana and Rane, Anjali. “Dividend Smoothing & Implications of Lintner’s Model: An Empirical Analysis of Indian Metal Section”. Inspira-Journal of Commerce, Economics & Computer Science (JCECS), vol. 4, no 1, 2018, pp. 41.
- New York Times. “John V. Lintner Jr., 67, Dies; Harvard Business Professor”.
