Dividend policy is an important factor for shareholders to consider in the stock-selection process because dividends are a major cash outflow for companies.
Dividend policy is an important factor for shareholders to consider in the stock-selection process because dividends are a major cash outflow for companies. In 2015 alone, for example, BSE-listed firms paid out in excess of $10 billion in cash dividends. At the same time, however, about 20% of the listed companies paid no dividend at all. At first glance, it may seem obvious that a company would always want to give back as much as possible to its shareholders by paying cash dividends. It might seem equally obvious, however, that a company could always invest the money for its shareholders instead of paying it out. This is a pertinent point to be noted by the current as well prospective shareholders of companies.
What is dividend?
The term dividend usually refers to cash paid out of earnings by the company to its shareholders. If a payment is made from sources other than current or accumulated retained earnings, the term distribution, rather than dividend, is used. However, it is acceptable to refer to a distribution from earnings as a dividend. More generally, any direct payment by the company to the shareholders may be considered a dividend. Dividends come in several different forms. The basic types of cash dividends are: Regular cash dividends, extra dividends and special dividends.
The most common type is cash dividend. Commonly, public companies pay regular cash dividends once in a year, i.e., between two balance-sheet dates, whereas in Western countries, dividends are paid four times in a year, i.e., in every quarter. As the name suggests, these are cash payments made directly to shareholders, and they are made in the regular course of business. Sometimes companies will pay apart from regular cash dividend and an extra cash dividend. By calling part of the payment ‘extra’, the management is indicating that the ‘extra’ part may or may not be repeated in the future. A special dividend is similar, but the name usually indicates that this dividend is viewed as a truly unusual or one-time event and won’t be repeated. A cash dividend payment reduces corporate cash and retained earnings.
To decide whether or not the dividend policy matters, we first have to define what we mean by dividend policy. All other things being the same, of course dividends matter. Dividends are paid in cash and cash is something that everybody likes. The heart of the dividend policy question goes like this: Should the company pay out money to its shareholders or should it keep that money, invest it and pay back later to its shareholders. Dividend policy, therefore, is the time pattern of dividend payout. In particular, should the firm pay out a large percentage of its earnings now or a small or even zero percentage? This is the dividend policy question.
Generally firms that have growth potential and are in need of cash do not pay any dividends whereas those grown and matured pay them. Contrary to the above, there are companies that pay a constant dividend irrespective of their performance and some firms pay a small token dividend and, based on the performance, pay dividends. Here, dividends will vary every year and it is known as a cyclical dividend policy. So, dividend policy of companies is controversial. Many implausible reasons are given for why dividend policy might be important, and many of the claims made about the policy are economically illogical. Even so, in the real world of corporate finance, determining the most appropriate dividend policy is definitely an important issue.
Determinants of dividend policy
There are various factors that determine the dividend policy of companies. These include growth, ability to raise funds in the capital markets, age, size of the company, taxes related to dividend receipt matters, amd so on. For instance, in countries where dividends received by shareholders are taxed higher than that of capital gains, shareholders generally prefer the firms not to pay dividends.
Generally, it is possible for shareholders to assess the dividend policy of companies, for which one needs to observe the dividend history of firms over a period of time. Once that is established, one can take a call on buying the stock.
For instance, if you are retired and/or a conservative investor, it is a good idea to invest your money in firms that pay regular dividends. If you are young, aggressive and looking forward to capital gains, it is a good idea to park your money in firms that do not pay dividend. Ensure that all the cash conserved by these firms are invested into the business to fuel their growth.
The writer is associate professor of finance & accounting, IIM-Shillong