A company’s dividend policy suggests the payout frequency, amount, and timings of the dividends paid out to its shareholders. Income-oriented investors are particularly keen on knowing a company’s dividend policy.
There are four types of dividend policies. Each type of policy offers its pros and cons to shareholders and the company. Proponents of dividend irrelevancy theory argue that a dividend policy is irrelevant.
Let us consider in detail; what is a dividend policy, does it matter to shareholders, and what types of dividend policies a company can follow.
What is a Dividend Policy?
A dividend policy is a formal plan that a company adopts to distribute dividends to its shareholders. It helps a company decide on the use of earnings to retain or distribute them to the shareholders.
When a company makes a profit, it needs to use them in two ways. Either the company can retain the profit and use it for reinvestment purpose, or distribute to the shareholders. A dividend policy is formed to decide how much of the profit should be retained and how much of it should be distributed. A company may also decide not to pay any dividends at all or pay all of it in the form of dividends.
A dividend policy also decides the type of dividend. A dividend can be paid in the form of:
- Cash dividend
- Stock dividend
- Hybrid dividend
- Payment-in-kind dividend
Usually, companies pay dividends quarterly. However, it may change the frequency to semiannually or annually.
How Does a Dividend Policy Affect Shareholders?
Proponents of dividend irrelevancy theory suggest a dividend policy does not affect shareholders. They argue shareholders can sell shares at any time. If shareholders consider the dividend satisfactory, they will retain the shares otherwise sell them.
Other views suggest a dividend policy does affect shareholders and their investment decision. A dividend policy sends signals to the stock market, whether positive or negative. If a company successfully implements its dividend policy and achieves desired goals, it will eventually achieve share price appreciation.
A dividend policy is particularly important for retail and corporate income-oriented investors. For example, retirees depend on dividend payments for a consistent income. Similarly, corporate entities like pension funds and trusts look for consistent dividends.
A Dividend policy may not affect traders and arbitragers, but it certainly affects income-oriented shareholders.
4 Types of Dividend Policies
There are 4 types of dividend policies. Each type comes with its pros and cons for the company and its shareholders. Remember, paying dividends is not an obligation for the companies. Thus, a dividend policy does not come as a regulatory obligation too.
Let us consider each type of dividend policy with its pros and cons.
Stable Dividend Policy
It is one of the most commonly adopted dividend policies around the world. Under this policy, a company pays out dividends regardless of the net income (loss) outcome. Shareholders would always receive dividends under this policy.
As the name suggests, this policy follows a stable and regular dividend payout. Shareholders that invest in dividend stocks prefer this type of policy. Shareholders can predict a consistent income through a stable dividend payout.
Established companies with accumulated cash reserves adopt a stable dividend policy. As they have to pay dividends whether they make profits or losses. Thus, it is sustainable for companies that have large cash reserves and accumulated profits. If a company does not make a profit or positive cash flow in an economic recession, it can afford a short-term loan to pay dividends.
Income-oriented and risk-averse investors prefer a stable dividend policy. They look for confirmed dividends rather than higher returns on investment. These investors also become a confidence booster for the company as they invest in such companies. Even if the company pays low dividends, investors would consider it a safe bet.
Constant Dividend Policy
Under this dividend policy, a company pays out a fixed percentage of profit as dividends to its shareholders. For example, a company may decide to pay out 10% of its profits as dividends to the shareholders annually. The frequency can be set at quarterly, semiannually, or annually payments.
If the company makes a higher profit, the shareholders will receive higher dividends. Conversely, if a company makes low or zero profit, shareholders will receive low or zero dividends. Thus, investors follow the stock volatility with this policy. It is a risky dividend policy for many investors. However, it can bring a higher return on investment in the long run as well.
Sometimes a company may adopt the constant dividend policy with little variation. It can set a constant dividend amount plus a percentage of profit as dividends. This way, the company would be able to keep its shareholders satisfied.
This type of dividend policy is risky. As investors receive fluctuating dividends with changing levels of profits. Thus, it does not attract income-oriented investors as such. However, the advantage of this policy is growth in dividend amount if the company makes consistent profits.
Residual Dividend Policy
Residual or irregular dividend policy is when a company pays out dividends only after paying off its capital expenditures and working capital requirements. A company first fulfills its investment and operational financing requirements before it makes a dividend payment. Hence the name residual (out of net profit) dividend policy.
Irregular or residual dividend policy is also risky and volatile. Yet this is one of the most liked dividend policies around. Investors consider this policy a logical one. If a company does not invest in positive cash flow projects, it cannot earn profit. Thus, reinvesting profits takes priority over dividend payments to shareholders.
Companies adopting residual dividend policy decide through their board of directors. The board may decide to pay dividends for one year and no dividend for the next year. Usually, the board decides for a dividend if the company makes a good profit and has surplus cash.
Risk tolerant investors like the residual dividend policy. They look for capital gains and enjoy dividend payout whenever available. Thus, a zero dividend does not affect their investment choice.
No Dividend Policy
No dividend policy is also a very commonly followed policy. Growth stage companies always want to retain earnings and use them for reinvestment. These companies will always adopt a no dividend policy.
Companies following a no-dividend policy will show a zero-payout ratio. Such companies retain all of their income and use it for reinvestment and growth requirements.
The main advantage of a no dividend policy is the cheaper cost of capital. A company retains cash flow and uses it for reinvestment projects. Thus, its reliance on equity and debt borrowing decreases. That in turn, decreases its total cost of capital.
A no dividend policy is not also bad for investors. Shareholders get a return on investment through dividends and capital gains. A company reinvesting in positive NPV projects and growth sends a positive signal to the market. It gains value over time through reinvesting and a lower cost of capital. Thus, investors enjoy a greater return on investment through capital gains in the long run. However, the policy is not suitable for income-oriented investors looking for consistent dividend payments.
There are four main types of dividend policies. Each dividend policy comes with its pros and cons for the company and its shareholders. Investors looking for consistent income would like stable and constant policies. Others may favor the residual and no-dividend policies.