What is a Dividend Policy?
When a company's earnings are sufficient to make a profit, it has two ways to use it—reinvest or distribute to its shareholders via regular dividend payments. Should it decide to distribute, a dividend policy provides the game plan for how to divvy up excess cash to shareholders. It also outlines when, how much, and how often money will be paid. Typically, dividend payments are made in the form of cash, stock, or payment-in-kind.
A dividend policy is a vital part of any organization’s strategy. If you’re getting your business degree, or plan to own your own company in the future, you should get familiar with dividend policies, the different types, and how they work. This article will help break it down for you.
What are the Types of Dividend Policies?
There are four main types of dividend policies: residual, stable, constant, and hybrid. Here’s a breakdown of each:
Residual Dividend Policy
In this policy, a company uses all excess cash to pay for operational needs first (reinvestment), then whatever’s left is paid out to shareholders. This is sometimes used by companies to set the dividend so that it doesn’t hamper its ability to pursue investment opportunities. A business that uses a residual dividend policy will need to constantly justify its payouts and fluctuations with shareholders. On the shareholder side, this policy often attracts investors that are looking for more long term gains and are indifferent to the amount or type of dividends they might receive in the short term.
Stable Dividend Policy
A stable policy is the most commonly used policy among the four types. With this policy, shareholders receive a certain minimum amount of regular dividend on a scheduled basis, but the amount or rate is not fixed. Investors that are risk-averse and income-oriented typically prefer this policy and consider it a safe bet, even if the company pays low dividends.
Hybrid Dividend Policy
The hybrid policy is basically a mix of the stable and residual policies. Companies that use this type of policy aren’t as rigid when it comes to quarterly debt-to-profit metrics as the only basis for the amount of dividend. Industries that focus on nonessential products use this policy the most because they’re more affected by business cycles. As business fluctuates, they pay a modest dividend that can be easily maintained but might also pay a supplemental dividend if business is good.
Constant Dividend Policy
Of the four policy types, this is considered the riskiest because investors receive fluctuating dividends with changing levels of profits. For this reason, the constant policy is not as ideal for income-oriented investors. However, the advantage of this policy is short or long term growth in dividend amount if the company makes consistent profits. If profits are up investors get a larger payback and vice versa if profits are down.
Income retained by a business after dividends are paid to shareholders is known as retained earnings. If you aspire to be in a leadership or management position, understanding these different types of policies can be helpful as it’s likely you’ll have input on your organization’s dividend policy down the road.
Why Your Company Should Have a Dividend Policy
Establishing a dividend policy is one of the most important things you can do when it comes to your company’s finances. It communicates your company’s financial strength and value, creates goodwill among shareholders, and drives demand for stocks.
A solid policy balances the interests of your shareholders, who want to maximize their investment returns, with those of your organization, which wants to ensure future financial success and growth. It gives clear direction for how your company’s profits will be allocated and aligns with your organization’s goals to ensure your money matches your mission.
Here are some other reasons to consider a dividend policy:
It informs investors.
While it doesn't necessarily affect share price, which is more tied to valuation and market fluctuations, a dividend policy is an important factor that investors consider when deciding what stocks to invest in. It tells them very clearly what they can expect by putting their money into your company and outlines the amount, method, type, and frequency of dividend distributions.
It provides internal direction.
A dividend policy sets a level of discipline that your company must follow with the use of cash flow. You know where all profits are going and are able to more carefully allocate your profits.
It builds trust.
A sound dividend policy suggests your company is well managed and profitable, which can help build trust and confidence among your shareholders.
It adds credibility.
Your company’s dividend policy communicates the value of your organization and sends a message about your future prospects and performance.
Arguments Against a Company Dividend Policy
Two of the most common arguments against dividend policies are:
1. A dividend policy is irrelevant because investors have the ability to create "homemade" dividends.
These analysts claim that investors looking for a steady income stream are more likely to invest in bonds (in which interest payments don't change), rather than a dividend-paying stock (in which value can fluctuate). Because their interest payments won't change, those who own bonds don't care about a particular company's dividend policy.
2. Little to no dividend payout is more favorable for investors.
Supporters of this argument point out that taxation on a dividend is higher than on a capital gain. This is based on the belief that an organization that reinvests funds (rather than paying them out as dividends) will increase the value of the organization as a whole and, consequently, increase the market value of the stock.
What Are Examples of a Company Dividend Policy?
Every organization has a dividend policy whether they realize it or not—because even the decision not to pay dividends is considered a “no dividend policy.” Many businesses that adopt this kind of policy do this to retain their cash flow and use it for reinvestment purposes. Berkshire Hathaway, Ford, and Amazon are prime examples of this.
On the flipside, some companies that do pay dividends include:
- American Express
- Johnson & Johnson
- Texas Instruments
What's Included in a Dividend Policy?
There are no hard and fast rules when it comes to creating a dividend policy, but most include a company objective, intention and strategic vision, and a declaration of a dividend. Effective policies are flexible so that they can respond to business cycles but firm enough to manage shareholder expectations. Typically, a board of directors or an organization’s leadership decide what information is included in a dividend policy.
Now that you know the basics of a dividend policy, you might be wondering how you can take your knowledge to the next level. Getting your online business degree is a great place to start and will equip you with the skills you need to land some of the most in-demand jobs in the business world.