Understanding dividend policy

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Financial wellness with Richmond Kwame Frimpong: Retirement Planning for All – (Part: II)
Richmond Kwame Frimpong

Financial Wellness  with Richmond Kwame Frimpong

If you are an investor, or considering investing – particularly in publicly traded stocks (listed on the stock exchange), it is important to know the dividend policy of the company(ies) you are considering. This is because dividend stocks, according to studies, historically outperform other stocks in the long run.

A dividend policy is how a company distributes profits to its shareholders. It is the portion of profit paid out to equity holders in respective proportions of shares held. Dividends can take the form of cash payments or shares of stock, and are paid to a class of shareholders. When a company makes a profit from its operations, it can decide either to retain the profit for re-investment into the company for growth and appreciate its stock value or pay out a portion of the profit as dividends to shareholders.

The set of guidelines that set out to determine what portion of a company’s profit will be paid to shareholders as the dividend is the company’s dividend policy. Two main theories have emerged on how relevant dividend is to investors. One is the dividend irrelevance theory – which basically proposes that issuance of dividends should have little to no impact on the stock price.

The second is the bird-in-hand theory – which argues that investors prefer dividends to future growth and capital gains from re-investing profit. Hence, it asserts that stocks that pay higher dividends are preferred as compared to stocks with lower dividend pay-outs or stocks that pay no dividends at all.

There are three main types of dividend policy:

  • Residual Dividend Policy

A residual dividend policy puts the organisation’s growth needs and investment before profit distributions. In other words, a company with a residual dividend policy pays whatever is left once all expenditure for growth/expansion has been taken into account. This means that shareholders receive the sums left after the company has taken the likes of capital expenditure, investment and working capital into account.

  • Stable Dividend Policy

A stable dividend policy, unlike residual, makes a consistent pay-out each year regardless of how the business has performed or what the growth needs are. Instead of basing the dividend on the company’s performance over the short-term, stable dividend policies are more closely linked with long-term prospects and forecasts. That makes stable dividend policy reliable and consistent, even if the business suffers short-term turmoil. A stable dividend policy company prioritises honouring the dividend pay-out even if it has had a bad year, dipping into cash reserves if profits are not enough to cover it – thus providing something of a safety net for shareholders.

  • Hybrid Dividend Policy

A hybrid dividend policy is essentially a blend of the residual and stable policies. Companies with this type of policy still use traditional metrics like debt-to-equity, but through a longer-term view. They do not stick as rigidly to just one policy type as the only basis for their dividend payout decision.

Factors that may influence a company’s decision to pay dividends or otherwise:

  • Is there a better use for profits?

the potential for better returns through the re-investment of profit is a very common factor that can affect the dividend policy of a company. If the management of a company believes that re-investing its profit will be more gainful to the company and its shareholders in the long run, it may choose not to pay dividends.

  • Does the company have a stable income?

Reputable companies with stable income or predictable income streams usually pay dividends, while a new company with growing or less predictable income streams would rather re-invest profits into its operations to fuel more future growth. Most companies with volatile revenues often pay no dividends or pay small dividends to ensure that the payout will be sustainable.

  • The state of the economy

A company’s dividend policy can also be influenced by the current market environment (micro and macro alike). This could happen to certain sectors of an economy; for example, if the oil and gas sector is facing a market downturn such as a decline in fuel prices and cannot clearly anticipate profits, it might suspend its dividend policy. Also, if a market regulatory regime requires that minimum capital requirements are raised, it could affect dividend payouts. Lastly, if macro-economic indicators are affecting the cost of doing business and neutralising business profits, companies can decide to postpone dividend payouts (the inverse is true).

  • Tax considerations

Since dividends are taxed twice – that is, at the corporate level and when they are paid out to shareholders – some companies (and their shareholders) may choose re-investment of profit. Hence, investors who like to reinvest their dividends may do so without having to worry about dividend taxes.

How to find out what a company’s dividend policy is

The best place to find a company’s dividend policy is in its annual report. Most publicly traded companies have a dividend section on their investor relations website. This usually focuses more on when dividends that have already been declared will be paid.

Seek Help

As an avid investor, you should be careful to choose stocks that support your expected dividend pay-out policy. For instance, if you identify with the bird-in-hand theory, then your choice of stock should favour a regular dividend policy rather than one that re-invests profits. A financial advisor can help to make such investment decisions.

You may send comments, questions or suggestions if any to [email protected] and @richmondkwamefrimpong across all social media platforms

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