What is the Lintner model?
In 1956, John Lintner, professor of economics and business administration at Harvard University in Ghent, proposed the Lintner model for corporate dividend policy, which focused on two basic concepts:
- A company’s target distribution rate
- The speed at which current dividends adjust to the target
Key points to remember
- The Lintner model is an economical formula for determining the optimal dividend policy for a company.
- The model focuses on the target dividend payout ratio and the time it takes for the increased dividends to turn out to be stable.
- By following the model, a company’s board of directors can easily assess the effectiveness of its dividend policy.
The formula of the Lintner model is
The following formula describes the payment of dividends from a mature company:
- Dividendt is the dividend at time t, the change compared to the previous dividend at period (t – 1)
- PAC <1 is a partial adjustment coefficient
- k is a constant
- et is the error term
Understanding the Lintner model
In 1956, John Lintner developed this dividend model through inductive research with 28 large public manufacturing companies. Today, although Lintner died years ago, his model remains the accepted starting point for understanding how corporate dividends behave over time.
Lintner observed the following important facets of corporate dividend policies:
- Companies tend to set long-term target dividend-profit ratios based on the number of positive net present value (NPV) projects available to them.
- The increase in earnings is not always sustainable. Therefore, the dividend policy will not change significantly until managers see that the new profit levels are sustainable.
While all companies want to maintain a constant dividend to maximize shareholder wealth, natural business fluctuations force companies to project dividends over the long term, based on their target payout ratio.
Using Lintner’s formula, the board of directors of a company thus bases its decisions on dividends on the company’s net current result, while adjusting them for certain systemic shocks, gradually adapting them to variations in income over time.
The Lintner model and the setting of corporate dividends
The board of directors of a company defines the dividend policy, including the payment rate and the distribution date (s). This is a case in which shareholders are unable to vote on this corporate measure (unlike cases like a merger or acquisition, and other critical issues like executive compensation) .
The three main approaches to corporate dividend policy are:
- The residual approach, whereby dividends are only drawn from residual or residual equity after meeting the specific capital requirements of the project. (In such cases, companies rely on internally generated equity to finance new projects.) Companies using the residual dividend approach generally try to maintain the balance of their debt / equity ratios before d ” make distributions.
- The stability approach, in which the board often fixes quarterly dividends at a fraction of annual profits. This reduces uncertainty for investors and provides them with a regular source of income.
- A hybrid of both the residual approach and the stability approach, in which the board of directors of a company considers the debt ratio as a longer-term objective. In these cases, companies usually decide on a fixed dividend which represents a relatively small portion of annual income and which can be easily maintained, as well as an additional dividend payment to be distributed only when income exceeds general levels.