Dividend Policy: Defined and Explained
By: Ned Piplovic,
A company’s dividend policy generally refers to a set of decisions and a set of guidelines that outline how the company handles distributions of earnings or assets to its shareholders.
The dividend policy is important because it outlines the magnitude, method, type and frequency of dividend distributions. At the highest level of decision making, companies have two basic options regarding what to do with their profits: retain or distribute the earnings.
The retention of profits allows their use for various business functions, including additional investing in expansion and growth. The distribution of excess profits to the shareholders can come in the form of either share repurchases or dividend distributions.
Once a company decides on what it wants to do with excess profits, it can start crafting the actual dividend policy. While a company’s dividend policy specifically determines the distribution of a company’s profits to its existing shareholders, the dividend policy can also be used as a powerful tool for attracting new investors and enticing preferential treatment from financial and credit markets.
To achieve these goals, companies must consider several aspects and constraints of dividend distributions before devising and implementing a dividend policy. Some of these considerations include taxation, contractual constraints, potential legal and regulatory roadblocks, long-term cash flow implications and more.
Another consideration is the impact of the dividend policy on the wealth and prosperity of the existing holders of the company’s common shares. While that might seem like a valid argument, figuring out investor preference is not as easy as it might seem on the surface. There are at least three major philosophies regarding dividend policy preferences.
- Certain investors prefer receiving their dividend distributions right away instead of deferring the current dividend income for an unknown level of capital gain – or loss – in the future. While some investors refer to this approach as the “bird in the hand” theory, it is commonly known as the Dividend Discount Model or the Gordon Model – named after economist Myron J. Gordon who expanded on an earlier paradigm to develop his model.
- Alternatively, other investors subscribe to the Modigliani-Miller Theorem – developed by economists Franco Modigliani and Merton Miller in the 1950s. This theorem claims that a company’s dividend policy has no impact on the level of long-term capital gains in perfect market conditions. Proponents of this theory argue that dividend payouts might be a good management strategy only if investment opportunities with high potential returns are unavailable. However, believers in dividend distributions claim that back-tested results indicate that companies with a dividend policy of rising dividends outperform the market in the long run.
- The last consideration deals with varied dividend taxation levels in different markets. Some countries tax dividend income at ordinary income rates, which can be significantly higher than tax rates for capital gains. In those instances, investors favor stock dividends, share repurchase programs or reinvestment of the earnings into growth opportunities, all of which provide potential for additional capital gains over the extended time horizon. However, many countries have tax policies that allow taxation of a specific dividend type – qualified dividends – at the same rates as capital gains, which alleviates some of the taxation impact concerns when companies choose what to do with their excess earnings.
Once the officers and top-level managers of the company evaluate all relevant aspects of their earnings management strategy, they have several options from which to choose their company’s dividend policy.
Dividend Policy Options
- No Dividends is a viable dividends policy and this policy choice aligns with the notions of the Modigliani-Miller Theorem. In this case, the company does not distribute any of its earnings as dividends to its shareholders. Instead, the company’s management allocates any excess earnings towards expansion and future growth.
- Regular Dividends Policy – or Stable Dividend Policy – has companies distribute dividends at a specific rate to its shareholders at predetermined intervals. Quarterly dividend distributions are very common because they align with corporate quarterly reporting of financial results. However, dividend distributions also can be paid annually, monthly or semi-annually. Because it mirrors their twice-per-year financial results reporting schedule, many European company’s favor the semi-annual distribution timeline.
Companies can implement this policy in several ways.
a. Constant Payout Ratio dividends distribute to shareholders a specific portion of the company’s earnings. Generally, a payout ratio of 30% to 50% is considered a sustainable level. The dividend distribution amount is directly proportional to the company’s earnings and allows for ease of management, as well as internal financing with retained earnings.
b. Constant Dollar Dividend is similar to the first policy above. However, instead of paying a predetermined share of the company’s earnings, this policy distributes a set amount of cash dividends. This policy allows individual investors who derive most of their income from dividend distributions to budget and plan their income and spending relatively easily. However, since the dividend payouts remain constant regardless of the earnings level, this policy could spell trouble for the company’s management to find enough funds for dividend payouts amid earnings fluctuations.
c. A combination of the first two policies, this approach calls for a company to commit to pay a small amount as a regular dividend and add any extra dividends in addition to the regular portion allowed by earnings. This policy allows management plenty of flexibility to operate the business and guarantees investors a portion of their regular dividend income.
- Irregular Dividends Policy is generally used when a company does not have a steady inflow of liquid funds or when the company’s earnings are not stable enough or fluctuate too much to allow for any kind of commitment to regular dividend distributions.
Some companies will also set up Dividend Reinvestment Plans (DRIPs). These plans allow shareholders to reinvest their dividend distributions back into the company. The companies have the option of either repurchasing existent shares or issuing new shares to fulfill the demands of the DRIP. In addition to investing dividend payouts back into the company, DRIPs offer several additional advantages to investors. Unlike shares purchased in the open market, investors can purchase fractional shares through DRIPs. Additionally, some companies also offer shares purchased through DRIPs at discounted prices and transactions are generally free of commissions and fees.
A company’s particular dividend policy conveys information to existing shareholders and potential new investors regarding the health of the organization’s current financials. Additionally, a positive dividend policy over extended periods also offers possible insights into a company’s prospective future outlook, at least in the near term.
Investors can interpret sudden changes in dividend distribution payouts or deviations from long-standing dividend policies as signs of potential downturns and divest their funds from the company’s stock. Alternatively, dividend hikes above the expected policy growth, could entice new investors to provide additional funding or existing shareholders to increase their existing positions.
There is no universal dividend policy. The Board of Directors and upper management of each company must determine the policy that is best suited to that company’s particular set of requirements and constraints. Therefore, each company should evaluate multiple factors and its own long-term strategies before selecting a dividend policy that is most likely to offer steady growth to please its shareholders.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.