Dividend Policy is an important aspect of investing in stocks. It can affect your investments and also returns. So, if you are new to investment, understanding dividend policy is essential for you.
Well, This beginner-friendly guide will provide you with an easy explanation of what it is and why it matters. Before you understand dividend policy, you first need to understand dividends.
What is a Dividend?
When a company earns profits, it has two options: it can either reinvest this profit into the business for growth and expansion or it can distribute it among the shareholders as dividends. Hence, A dividend is a payment made by a company to its shareholders out of the profits it has earned.
If a company chooses to pay dividends, it announces the timings and amount of the dividend payment. A dividend can be paid in the form of cash, stock, or other assets. However, not all companies pay dividends.
What is A Dividend Policy?
When a company earns profits and decides to pay dividends to its shareholders, it has to make decisions about how much of its earnings to distribute to shareholders as dividends and how frequently those dividends are paid. A dividend policy helps the company decide it.
A dividend policy refers to a set of guidelines or principles that a company uses to determine how much of its earnings to distribute to shareholders as dividends and how much to retain for future growth opportunities.
Types of Dividend Policy
There are several types of dividend policies that a company may choose. Some of the most common types include:
1. Regular Dividend Policy
Under a regular dividend policy, a company pays a fixed amount of dividend to its shareholders on a regular basis such as quarterly or annually. If a company generates high profits, it retains the profits while when the company faces a loss, it still pays the dividends.
2. Irregular Dividend Policy
As the name suggests, under this policy, shareholders may or may not get dividends on a timely basis. If a company plans to expand, it may choose not to pay dividends. Another time it may choose to pay.
3. Stable Dividend Policy
Under this dividend policy, a company pays a fixed percentage of profits to its shareholders on a yearly basis. This is done for the company’s long-term growth. The goal is to provide its shareholders with a reliable source of income while also allowing the company to future growth.
4. Residual Dividend Policy
In this policy, a company distributes its profits among its shareholders after all necessary investments in growth and development have been made. This ensures that the company has enough funds for future growth while still rewarding the shareholders.
5. Low-payout Dividend Policy
Low-payout dividend policy involves paying a small percentage of profits as dividends to the company’s shareholders and the majority of profits are reinvested back into the business for long-term growth.
6. High-payout Dividend Policy
In this policy, a company pays out a large percentage of its profits as dividends. It can be attractive for income-seeking investors while it can limit the company to invest in growth opportunities.
7. No Dividend Policy
Under this policy, a company does not pay dividends to its shareholders and retains all the profit with it. It helps the company to expand and grow further.
Determinants (Factors) of a Dividend Policy
There are several factors that contribute to creating a company’s dividend policy. Some of the most influential factors or determinants include:
A company’s profitability and cash flow are the two main key factors in determining the company’s ability to pay dividends. A company that generates a consistent profit is more likely to pay dividends to its shareholders.
2. Industry Norms
It is another determinant of a company’s dividend policy. Companies in certain industries that have stable cash flows and predictable profits are expected to pay higher dividend payouts.
3. Shareholder Preferences
The preferences of the company’s shareholders, including their desire for current income versus capital appreciation, may influence the dividend policy.
4. Growth Opportunities
Companies that have growth opportunities may choose to pay lower dividends and reinvest the rest funds into the business for future growth. Conversely, companies with fewer growth opportunities may pay out a larger percentage of earnings in dividends to reward shareholders.
5. Financial Flexibility
The company’s financial flexibility and the ability to access the capital market can also impact its dividend policy. If a company has limited access to capital, it can choose to conserve funds and pay lower dividend payouts.
Companies may consider the tax implications of their dividend policy, including the impact on shareholders and the company’s tax liability.
7. Legal Constraints
Legal restrictions, such as debt covenants or regulatory requirements, may limit a company’s ability to pay dividends.
Why Do Companies Pay Dividends?
Not all companies pay dividends but the ones that pay, do it for various reasons. One of the main reasons is to attract and retain shareholders. They make their stock more attractive for investors who want a steady source of income.
Which type of dividend policy should an investor choose?
Those who want a regular income can choose companies with a consistent history of paying dividends. On the other hand, Investors seeking capital appreciation may prefer companies that reinvest their earnings into growth opportunities rather than paying dividends.
Why should an investor know about a company’s dividend history?
A company’s dividend history tells about the financial health and stability of a company. Additionally, it also describes the company’s commitment to its shareholders which helps investors to produce future expectations.