What Is a Dividend Policy?
A dividend policy is a policy a company uses to structure its dividend payout. Put simply, a dividend policy outlines how a company will distribute its dividends to its shareholders. These structures detail specifics about payouts, including how often, when, and how much is distributed. There are three different types of dividend policies—stable, constant, and residual—each with its own benefits. Dividend policies aren't mandatory, as some companies choose not to reward shareholders with dividends.
Key Takeaways
- A dividend policy dictates the structure of a company's dividend payout.
- Dividends are often part of a company's strategy.
- Stable, constant, and residual are the three types of dividend policy.
- Even though investors know companies are not required to pay dividends, many consider it a bellwether of that specific company's financial health.
:max_bytes(150000):strip_icc()/TermDefinitions_DividenPolicy_recirc_3-2-e2e37ae4e643448383899aa6783950cd.jpg "Dividend Policy: What It Is and How the 3 Types Work (1)")
How a Dividend Policy Works
Some companies choose to reward their common stock shareholders by paying them a dividend. A dividend is paid on a regular basis and usually represents a portion of the profits that these companies earn. This gives shareholders a regular stream of income, which is why dividend-paying stocks are a favorite for some investors.
Having a dividend policy in place is important for dividend-paying companies. This is a structure that highlights several key points, including:
- How often dividends are paid out (monthly, quarterly, or annually)
- When they are paid
- How much to pay shareholders
These decisions are made by a company's management team. It must also decide what, if any, other factors may have to be put in place that would influence dividend payments. An additional factor to consider includes providing shareholders with the option to take their dividends in cash or allowing them to reinvest them by purchasing additional shares through a dividend reinvestment program (DRIP).
There are three types of dividend policies: a stable dividend policy, a constant dividend policy, and a residual dividend policy. These are highlighted in more detail below. Companies that choose not to pay their shareholders a dividend have no dividend policy, as paying a dividend isn't mandatory. Their focus may be to grow their businesses by reinvesting their profits.
Some researcherssuggestthe dividend policy is theoretically irrelevant because investorscan sell a portion of their shares or portfolio if they need funds. This is the dividend irrelevance theory, which infers that dividend payoutsminimally affect a stock's price.
Types of Dividend Policies
Stable Dividend Policy
A stable dividend policy is the easiest and most commonly used. The goal of this policy isto provide shareholders with a steady and predictable dividend payout eachyear, which is what most investorsseek. Investors receive a dividend regardless of whether earnings are up or down.
The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach givesthe shareholdermore certainty concerningthe amount and timing of the dividend.
Constant Dividend Policy
The primary drawback of the stable dividend policy is that investors may not see a dividend increase in boom years. Under the constant dividend policy, a company pays apercentage of its earnings as dividends every year. In this way, investors experience the full volatility of company earnings.
If earnings are up, investors get a larger dividend and if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially 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. Witha residual dividend policy, the company pays out what dividends remainafter the company has paid for capital expenditures (CAPEX) and working capital.
This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends.
Despite the suggestion that the dividend policy may be irrelevant, it is income for shareholders. Company leaders are often the largest shareholders and have the most to gain from a generous dividend policy.
Example of a Dividend Policy
Kinder Morgan (KMI) shocked the investment world when in 2015 it cut its dividend payout by 75%, a move that saw its share price tank. But many investors found the company on solid footing and making sound financial decisions for their future.
In this case, cutting its dividend actually worked in its favor. Six months after the cut, Kinder Morgan saw its share price rise almost 25%. In early 2019, the company raised its dividend payout again by 25%, which helped to reinvigorate investor confidence in the energy company.
What Are Dividends?
Dividends are paid by companies to their common shareholders. They represent a portion of the corporate earnings or profits that companies want to share with their investors. Dividends are paid at regular intervals, either monthly, quarterly, or annually. As such, they provide a regular stream of income for investors. Dividends are commonly offered by companies whose primary focus isn't growth. Major companies like Coca-Cola, Apple, Microsoft, and Exxon Mobil.
What Are the Main Types of Dividends?
Dividend-paying companies have several options when it comes to the type of dividend they offer shareholders. They can pay dividends in cash, which is the most common type, or they can offer stock dividends, give shareholders additional (existing) shares in the company. Other, less common types of dividends are the scrip dividend, property dividend, and special dividend.
Do All Companies Pay Dividends to Their Shareholders?
No, not all companies pay dividends to their shareholders. And they are not mandatory. A company's board of directors decides what to do with its profits. Some choose to reinvest the money they earn back into the company to fuel growth. These companies have no dividend policy. Others choose to take a portion of the profits and pay dividends to their investors on a regular basis.
The Bottom Line
Dividend-paying stocks can give you a steady stream of income while adding value to your portfolio. But before you jump in, make sure you review the dividend policies of certain companies. These policies are set by corporate management and highlight how much to pay, when, and how often.
