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 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 some researchers suggest the dividend policy is theoretically irrelevant because investors can sell a portion of their shares or portfolio if they need funds this is the dividend irrelevance theory which infers that dividend payouts minimally affect a stock s price types of dividend policiesa stable dividend policy is the easiest and most commonly used the goal of this policy is to provide shareholders with a steady and predictable dividend payout each year which is what most investors seek 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 gives the shareholder more certainty concerning the amount and timing of the dividend 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 a percentage 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 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 out what dividends remain after 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 some companies decide not to pay dividends at all particularly those in high growth industries or early stage startups reinvesting profits to fuel expansion these companies prioritize reinvestment of earnings into research development acquisitions or debt reduction rather than distributing dividends by forgoing dividends the company aims to accelerate growth and enhance shareholder value through a higher future stock price rather than income generation note that this type of policy may actually still be documented a hybrid dividend policy combines elements of the different policies above for example a manufacturing company might adopt a hybrid policy by offering a stable base dividend supplemented by additional payouts based on residual earnings from exceptional periods or one time gains this approach allows flexibility so that investors can expect a baseline amount of dividends but also realize they may be awarded higher dividends if operations go well importance of dividend policiesa dividend policy is a financial guide that helps management issue dividends this clarity is essential because it sets expectations among investors about what potential income they might get from their investments for income oriented investors like retirees or those who are risk averse a predictable dividend stream provides assurance and helps them plan their finances like they might want or need it also attracts a certain segment of investors who prefer stable income over capital appreciation second a well defined dividend policy enhances transparency and credibility in the eyes of investors a company is not required to issue dividends and it may choose to stop paying a dividend at any time by committing to a specific dividend policy companies demonstrate their financial discipline and intention to not only generate consistent cash flows for the company but to distribute this cash next a dividend policy can influence the company s cost of capital and shareholder value consistently paying dividends or increasing dividends over time can enhance the company s attractiveness to investors in the long run this can lower its cost of equity and increase the net proceeds of what it s able to raise for future share issuances this is because dividends provide tangible returns to shareholders making the stock more appealing meaning the company can sell new shares in the future at higher offerings last a dividend policy helps set a company s overall corporate strategy for mature companies in stable industries a dividend policy could reflect the fact that the company isn t looking to scale and is probably going to maintain its operations on the other hand growth oriented companies may choose not to pay dividends and reinvest earnings into expanding operations or acquiring new technologies in both cases the dividend policy communicates this strategic plan and can be somewhat of a roadmap for management when thinking about future plans regarding cash example of a dividend policykinder 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 12