Dividend Policy: What it is, Overview and Types

What is a Dividend Policy?

A dividend policy is a set of guidelines or rules a company follows when deciding how much of its profits to distribute to its shareholders as dividends.

In India, the dividend policy is determined by the company's Board of Directors, considering the company's financial performance, future investments, capital requirements, and other factors.

Example: Here's a dividend policy of MSTC Limited, a government-owned e-commerce enterprise.

Objectives of a Dividend Policy

The objectives of a dividend policy in a company are multifaceted and can vary depending on the organization's goals and circumstances. However, some common objectives include:

1. Provide Shareholder Return: A dividend policy rewards shareholders by distributing a portion of profits as dividends. This attracts new investors and provides a return on investment.
2. Maintain Investor Confidence: Consistent dividend payments boost investor confidence in the company's financial stability, positively affecting the stock price and market perception.
3. Capital Allocation: A dividend policy decides how much of earnings should be retained for reinvestment (e.g., for expansion, research) and how much should be distributed as dividends.
4. Tax Considerations: A dividend policy takes into account tax implications for shareholders.
5. Access to Capital: Dividends attract income-oriented investors, broadening the investor base and providing access to a different class of shareholders.
6. Signal Financial Health: Consistent dividend payments signal financial stability and confidence in future prospects.
7. Flexibility: The dividend policy can adapt to changing economic conditions and business needs.
8. Competitive Advantage: A well-structured dividend policy can distinguish a company from others in the same industry and attract long-term investors.
9. Align Interests: Dividends align the interests of management and shareholders, benefiting executives holding stock options or shares.
10. Shareholder Satisfaction: Consistent dividend payments foster loyalty and reduce the likelihood of activist shareholders or hostile takeovers.

What Are The Factors Affecting a Dividend Policy?

1. Profitability

A company will declare a dividend only if it has made a profit. The company's profits also determine the proportion of dividends distributed among the shareholders.

2. Dividend Payment History

Generally, a company with a history of paying dividends to its shareholders keeps its dividend amount stable. These are dividend stocks where most investors park their money to earn a regular dividend income.

3. Growth Plans and Availability of Funds

A business might retain its profits if it has plans to reinvest them to expand. However, if the company's retained earnings are enough to fund its expansion, it may pay dividends.

4. Dividend Trends in the Industry

Companies might match the dividend trends that exist in their industry to retain their shareholders.

How are Dividends Distributed?

A company's dividend policy determines the pattern of dividend distribution. Here are 4 ways in which dividends are distributed in India:

1. Stable Dividend

In this pattern, shareholders receive a fixed dividend amount occasionally. This stability in distributing dividends is unaffected by the earnings of the company. With this dividend policy, the company pays shareholders a dividend even if they are making losses. 

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2. Regular Dividend

Companies following a regular dividend pattern fix a percentage of their profits to be given as dividends. With a higher yield, the company pays a higher and lower dividend when it makes a smaller profit.

3. Irregular Dividend

Here, the company decides to pay a special dividend to the shareholders — on a case-to-case basis. The company chooses the dividends per its priority. For example, if the company plans to expand, it might reinvest its profits and decide not to pay dividends.

4. No Dividend

A company following a no-dividend policy retains all its profits and does not distribute them among its shareholders.

Types of Dividends

If a company has decided to pay dividends to its shareholders, the next crucial decision it needs to make is the dividend payout ratio. The dividend payout ratio measures how much you can get for each of the shares you hold.

EPS is a figure that describes the profit amount per share of the company. Companies must also decide what form of dividend they will payout to shareholders. There are four major types of dividends.

1. Stock Dividends

Dividends can be given by granting additional shares to existing shareholders. A company can issue less than one-fourth of its previously issued stock in stock dividends. However, if the company provides additional shares in the form of a stock split, it can surpass this limit.

2. Cash Dividends

Cash dividends are amongst the popular forms of dividends in India. Here, the company pays its shareholders a fixed amount per share. For example, if the dividend rate is 5% and you have 100 shares of the company, your cash dividend value would be 5 x ₹100 = ₹500.

3. Property Dividends

Sometimes, a company issues a non-financial dividend to its shareholders, such as a property dividend. These dividends can include giving shares of a subsidiary company (another company under a parent brand) as dividends. The value of the property dividend is considered against the asset's current market price. For example, Marvel Entertainment is a subsidiary of Walt Disney Entertainment. If Disney gives Marvel's shares as dividends, they are called property dividends.

4. Scrip Dividends

A scrip dividend is an 'I-owe-you' note that a company issues to its shareholders when it does not have enough dividends. This promissory note indicates that the company will pay dividends to its shareholders later. These dividends are usually cash dividends.

Note: Apart from these four types, a company might also pay liquidating dividends to its shareholders when it is wrapping up its business to return the capital invested by the shareholders.

Differences Between Interim and Final Dividends

Conclusion

Before investing in dividend-providing companies, shareholders must consider the company's dividend policy. Factors such as profitability, dividend payment history, growth plans, industry trends, and availability of funds influence the dividend policy. By understanding these concepts and the patterns of dividend distribution, investors (like you) can make informed decisions and maximise their returns.

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Frequently Asked Questions

1. What is a dividend policy? What are the factors that shape it?

A company's dividend policy is a guideline to determine the type, period and pattern of distributing dividends. The factors that impact a company's dividend policy are:

• The profitability of a company.
• Availability of funds.
• Growth plans.
• Dividend history of the company.
• Dividend trends in the industry.

2. What is the formula of a dividend policy?

The dividend policy is used to decide on the dividend payout ratio of a company. The dividend payout ratio of a company is calculated as the annual dividend per share divided by Earnings Per Share (EPS).

3. What are the benefits of a dividend policy?

The dividend policy equally benefits the company and the shareholders in the following ways: 
‍ For companies: 

• Shareholders exhibit more trust in a company that pays periodic dividends
• Regular dividend payments attract investors who want to earn a steady income

For shareholders: 

• The dividend policy clearly and transparently states the terms of dividend distribution
• Shareholders of a dividend stock can earn dual income.

4. What are the three types of dividends?

The three types of dividends are -

Stock dividends: Dividends can be given in the form of granting additional shares to existing shareholders. 
‍ Cash dividends: The company pays a fixed amount per share to its shareholders. 
‍ Property dividends: These can include shares of a subsidiary company (another company under a parent brand) as dividends.

5. What are the various theories of dividends?

1. Bird-in-the-Hand Theory: This suggests that investors prefer to receive dividends now rather than in the future because future dividends are uncertain.
2. Tax Preference Theory: This theory suggests that investors prefer capital gains over dividends because capital gains are taxed at a lower rate than dividends.
3. Agency Cost Theory: Dividends are a way for managers to signal their confidence in the firm's future prospects to investors. By paying dividends, managers show they have enough cash to meet current obligations and still have money left to distribute to shareholders.
4. Information Signaling Theory: Firms that pay higher dividends are seen as having more stable earnings and better growth prospects, which can lead to higher stock prices and lower capital costs.
5. ‍ Clientele Effect Theory: This theory suggests that different investors prefer different dividend policies. For example, income-oriented investors may prefer high dividend payouts, while growth-oriented investors may prefer low or no dividend payouts. Therefore, firms may adopt different dividend policies to attract and retain different types of investors.