What is the dividend policy?
Dividend policy is the policy used by the company to arrange the distribution of dividends to shareholders. Some researchers argue that dividend policy is theoretically irrelevant because investors can sell parts of their stocks or portfolio if they need the funds. This is the dividend irrelevance theory, which infers that dividend payments have minimal impact on the stock price.
- Dividends are often part of a company’s strategy. However, they are not obligated to use dividends to reward shareholders.
- Stable, constant and residual are three types of dividend policies.
- While investors know a company doesn’t need to pay a dividend, many see it as a bellwether for that particular company’s financial health.
How the dividend policy works
While some argue that dividend policy is irrelevant, it is shareholder income. Company leaders are often the largest shareholders and benefit the most from generous dividend policies.
Most companies view dividend policy as an integral part of their corporate strategy. Management must decide the dividend amount, timing and various other factors that affect dividend payments. Dividend policies are divided into three types – stable dividend policy, constant dividend policy and residual dividend policy.
Types of Dividend Policies
Stable Dividend Policy
A stable dividend policy is the simplest and most commonly used. The goal of this policy is stable and predictable dividend payments each year, which is what most investors seek. Investors receive dividends whether earnings rise or fall.
The goal is to align the dividend policy with the company’s long-term growth rather than quarterly earnings volatility. This approach gives shareholders more certainty about the amount and timing of the dividend.
Continuing dividend policy
The main disadvantage of a stable dividend policy is that investors may not see dividend increases during boom times. Under a fixed dividend policy, the company pays out a certain percentage of its earnings as dividends each year. In this way, investors can experience the full range of volatility in a company’s earnings.
If earnings rise, investors will receive a larger dividend; if earnings fall, investors may not receive a dividend. The main disadvantage of this method is the volatility of earnings and dividends. Financial planning can be difficult when dividend income is highly volatile.
Residual Dividend Policy
The residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend policy. With a residual dividend policy, the company pays the dividends remaining after capital expenditures (CAPEX) and working capital.
This approach is unstable, but it makes the most sense in terms of business operations. Investors don’t want to invest in a company that justifies its increased debt needs to pay a dividend.
Dividend Policy Example
Kinder Morgan (KMI) stunned the investment community in 2015 by cutting its dividend payment by 75%, a move that sent its shares plummeting. However, many investors found the company on solid footing and made sound financial decisions for their future. In this case, a company that slashed its dividend actually worked in their favor, with Kinder Morgan shares up nearly 25% six months after the dividend cut. In early 2019, the company raised its dividend payment by another 25%, a move that helped restore investor confidence in the energy company.