Dividend Policy
What Is a Dividend Policy?
A dividend policy is the policy a company uses to structure its dividend payout to
shareholders. Some researchers suggest the dividend policy is irrelevant, in theory,
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.
KEY TAKEAWAYS
Dividends are often part of a company's strategy. However, they are under no
obligation to repay shareholders using dividends.
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.
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What Is A Dividend?
How a Dividend Policy Works
Despite the suggestion that the dividend policy is irrelevant, it is income for
shareholders. Company leaders are often the largest shareholders and have the most to
gain from a generous dividend policy.
Most companies view a dividend policy as an integral part of their corporate strategy.
Management must decide on the dividend amount, timing, and various other factors
that influence dividend payments. There are three types of dividend policies—a stable
dividend policy, a constant dividend policy, and a residual dividend policy.
Types of Dividend Policies
Stable Dividend Policy
A stable dividend policy is the easiest and most commonly used. The goal of the policy
is a steady and predictable dividend payout each year, which is what most
investors seek. Whether earnings are up or down, investors receive a dividend.
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.
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
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; 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
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.
Example of a Dividend Policy
Kinder Morgan (KMI) shocked the investment world when in 2015 they cut their
dividend payout by 75%, a move that saw their share price tank. However, many
investors found the company on solid footing and making sound financial decisions for
their future. In this case, a company cutting their dividend actually worked in their
favor, and six months after the cut, Kinder Morgan saw its share price rise almost 25%.
In early 2019, the company again raised its dividend payout by 25%, a move that helped
to reinvigorate investor confidence in the energy company. 1
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