The Lintner Model

What Is the Lintner Model?

The Lintner model is an economic formula for determining an optimal corporate dividend policy. It was proposed in 1956 by former Harvard Business School professor John Lintner and focuses on two core notions:

1. An organization's target payout ratio
2. The speed at which current dividends adjust to the target

Though initially a descriptive model intended to explain how firms are observed to set dividends, the model has likewise been used as a prescriptive model of how firms should set dividend policy.

Understanding the Lintner Model

The accompanying formula describes a mature corporation's dividend payout:
$\begin&D_t=k+PAC(TD_t-D_)+e_t\&\textbf\&D=\text\&\text_t \text\&\text{$t$, the change from the previous}\&\text(t-1)\&\text=\text<1\text\&\text\&TD=\text\&k=\text\&e_t=\text\end$
In 1956, John Lintner developed this dividend model through inductive research with 28 large, public manufacturing firms. Although Lintner passed away years prior, his model remains the accepted starting point for understanding how companies' dividends behave over time.

Lintner observed the accompanying important facets of corporate dividend policies:

1. Companies tend to set long-run target dividends-to-earnings ratios according to the amount of positive net present value (NPV) projects they have available.
2. Earnings increases are not sustainable 100% of the time. As a result, dividend policy won't materially change until managers can see that new earnings levels are sustainable.

While all companies wish to sustain a constant dividend payout to maximize shareholder wealth, natural business fluctuations force companies to project the dividends over the long haul, based on their target payout ratio.

From Lintner's formula, an organization's board of directors thus bases its decisions about dividends on the firm's current net income, yet adjusts them for certain systemic shocks, gradually adapting them to shifts in income over time.

The Lintner Model and Setting Corporate Dividends

An organization's board of directors sets the dividend policy, including the rate of payout and the date(s) of distribution. This is one case in which shareholders are not able to vote on a corporate measure — unlike a merger or acquisition, and additional critical issues like executive compensation.

The three fundamental approaches to corporate dividend policy are as per the following:

1. The residual approach, in which dividend payments come out of the residual or leftover equity solely after specific project capital requirements are met. Companies utilizing the residual dividend approach generally attempt to maintain balance in their debt-to-equity (D/E) ratios before making any distributions.
2. The stability approach, in which the board often sets quarterly dividends at a fraction of yearly earnings. This reduces uncertainty for investors and provides them with a steady source of income.
3. A hybrid of both the residual approach and stability approach, in which an organization's board views the D/E ratio as a longer-term goal. In these cases, companies typically decide on one set dividend that is a relatively small portion of yearly income and can be easily maintained, as well as an extra dividend payment to distribute just when income exceeds general levels.

Highlights

• By following the model, an organization's board of directors can easily evaluate the effectiveness of its dividend policy.
• The model focuses on the target dividend payout ratio and on the time it takes for increased dividends to prove stable.
• The Lintner model is an economic formula for determining the optimal dividend policy for a firm.