What is a Dividend Policy?
Dividend policy is the policy that the company adopts for paying out the dividends to the company’s shareholders, which includes the percentage of the amount at which the dividend is to be paid out to the stockholders and how frequently the amount is paid to the company.
Simply put, a dividend policy is a set of guidelines or rules that the company frames for distributing dividends in years of profitability. It enhances an investor’s confidence during the dividend’s distribution. Generally, listed companies draft their dividend policies and keep them on the website for the investors.
The above snapshot is an example of Telefonica.
Table of contents
- Dividend policy refers to a set of principles or criteria the corporation defines for delivering dividends to its shareholders in years of profitability. It is a structure of rules that a company uses to distribute dividends to its shareholders.
- A dividend policy is a public document and thus needs the following components, objective/vision while declaring the dividend, laws applicable concerning the dividends, utilization of retained earnings, etc.
- There are certain pros and cons to dividend policing. Perks are that the company’s intent becomes visible, and trends of dividends are readily available. However, some cons are that the constant dividend payout changes.
Components of Dividend Policy
An ideal policy will give the following answers:
- Why this policy?
- What will the policy mean in practice?
- What are the risks and constraints associated with this policy?
- What was done in practice to deliver under the policy?
Under any law, there is no specified format provided that all companies have to follow.
It has the following components:
- Objective, intention, and strategic vision while declaring the dividendDeclaring The DividendDividend declared is that portion of profits earned that the company’s board of directors decides to pay off as dividends to the shareholders of such company in return to the investment done by the shareholders through the purchase of the company’s securities.
- Laws applicable to companies concerning dividends
- Discretion of the board for the declaration of dividends
- The utilization of Retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. for distribution
- The calculation process followed at the time of the declaration of the dividend.
- Factors to be considered while calculating the profit and earnings available for shareholdersEarnings Available For ShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.
- Revision and availability of the policy
An ideal policy should have the components mentioned above. Companies have to formulate the dividend policy based on their plans and policies, get it approved by investors, and keep it available for the public on their website.
Various dividend policiesTypes Of Dividend PolicyA Dividend Policy is a business strategy that deals with the amount of dividend to be paid & the frequency of payment. It has 4 major types, i.e., Regular Dividend, Stable Dividend, Irregular Dividend, & No Dividend Policy. are based on the company’s intent to distribute them. The payout ratio RatioThe payout ratio formula calculates the amount announced as a dividend out of the total earnings (after-tax profits). There are two formulas to calculate the dividend payout ratio using the earning method and the outstanding method. Payout ratio (earning method)= Total dividend paid/Total earning. and intent to progress the dividend payment determine all the policies.
It can be a regular policy, stable policy, constant dividend per shareDividend Per ShareDividends per share are calculated by dividing the total amount of dividends paid out by the company over a year by the total number of average shares held., constant dividend payout ratio, etc. All the policies have their facts, which apply to suitable market scenarios.
Example of Dividend Policy
“Dividends are only one part of the total returnTotal ReturnThe term “Total Return” refers to the sum of the difference between the opening and closing value of all the assets over a particular period of time and the returns thereon. To put it simply, the changes in opening and closing values of assets plus the number of returns earned thereof is the Total Return of the entity over a period of time. that investors receive, but for many, it is the most important part, and therefore good disclosure is fundamental.”
In the UK, in 2014, the Financial Reporting Council’s Reporting Lab initiated Project Lab for the companies listed under UK stock exchanges. Under this, they urged all the listed companies to disclose the dividend policy and capacity adequately. It should also represent any constraints the company can face while declaring the dividend. Furthermore, they were required to disclose their strategic intent.
This project assists investors in the UK in understanding companies better, along with their current practices and future strategic aspects of the payout through the dividend. As per the project, about 40% of the companies covered gave information about distributable profits.
Pros and Cons
A dividend policy reflects management thinking. Based on this perception, investors can consider the given policy beneficial or detrimental.
However, the following are the advantages –
- Investors will invest based on a company’s fund requirements and earning strategy by checking the dividend policy. The intent of the company becomes visible: Suppose there is a company rigorously paying a dividend in the market. At the same time, there are companies whose primary intention is to plow back the funds and reinvest the same in their business.
- Trends of the dividend payout will be readily available: Investors will need to verify the past movement of the company to declare the dividend. In this policy, it will be readily available. Hence, it will be a one-stop source of information about the dividends.
However, the following are the cons –
- Deviation from the constant dividend payout: Any change in the dividend payout policy or trend will directly impact the company’s market image. It guides an analyst, and any deviation may crash the prices of the shares.
- Future borrowing of funds: As discussed above, this also guides the market and fund providers. Fund providers will always ensure that their funds are used for business purposes and not as dividends by getting distributed to promoters.
Modification and Changes
Any modification in the dividend policies will require the shareholders’ approval. In addition, if any material changes are undertaken from statutory requirements, it is necessary to intimate the concerned state department.
Such modifications affect the mindset of investors, analysts, and credit rating agencies. Hence, it is of utmost importance to remain alert and cautious while making changes in the policy. Moreover, such policy changes require strategic thinking duly supported by future business aspects.
In the market scenario, corporations will always try to provide policy guidelines in a highly generalized manner, giving insight to the investor. No specific transaction-related data is disclosed, and thus, no additional disclosure is needed to be added or modified in the future.
As per the Financial Reporting Council of the UK, dividend disclosures are fundamental to companies and investors as they are essential in demonstrating and assessing board stewardship and investment. In addition, such disclosures help comprehend the future strategic thinking and liquidity risksLiquidity RisksLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases. that companies can face. Also, investors can determine the fair value of a company’s shares concerning their market price. However, it is highly complex to determine the profit distributable by any company.
Frequently Asked Questions (FAQs)
Companies maintain the stability of dividend policy by giving constant dividends per share. The business pays out a set amount in cash dividends. It builds a reserve that enables them to continue paying a set dividend even during poor earnings or losses.
Certain factors, such as legal restrictions, liquidity, profit margin, rate of asset growth, debt repayment, losses, etc., affect the company’s dividend policy.
A company may adopt a residual dividend policy, wherein the dividends are given to shareholders equal to the profits after capital expenditures (CapEx) and working capital expenses have been covered.
The choice of an investment opportunity affects a company’s dividend distribution strategy. Increased investment opportunities for a company lead to higher dividend payout ratios and higher dividend yields.
This article has been a guide to what Dividend Policy is. Here we discuss the critical components of dividend policy, practical examples, and its pros and cons. You can learn more about financing from the following articles –