Dividend policies are one of the important decisions taken by the company. Several factors affect the payout policy of the company, which includes various types of dividends model as well as repurchasing shares. Dividend policies can be framed as per the requirements of the companies. Shares repurchases are becoming more relevant and common in the recent times.
Definition of Dividend Policy
Dividend policy of a company is the strategy followed to decide the amount of dividends and the timing of the payments. There are various factors that frame a dividend policy of the company. Availability of better investment opportunities, estimated volatility of future earnings, tax considerations, financial flexibility, flotation costs, and various other legal restrictions affect a company’s dividend policy. There are various famous theories on dividend policy as stated below:
Types of Dividend Policies
There are three types of dividend policies depending on the amount and the frequency of the dividend payouts:
- Stable Dividend Policy
- Constant Dividend Policy
- Residual Dividend Policy
Stable Dividend Policy
Under the stable dividend policy, the company aims for a steady dividend payout every year. It does not change even if the earnings are volatile every year. The approximate level of the dividend payout is determined by looking at a forecast of the company’s long-term earnings. This approach aligns the dividend growth rate of the company with its long-run earnings growth rate.
The stable dividend policy is the most popular dividend policy. Under this approach, short-term earnings’ volatility is not reflected in the payouts. Hence, the shareholders can be least uncertain about the future dividends’ level. This policy has the following very real possibilities:
- Dividends may rise even in periods when earnings of the company decline.
- Dividends may not increase at the same higher rate of earnings in the booming years.
Because of these, the stable dividend policy may gradually move towards a target payout ratio. A target payout ratio is defined as a strategic goal which represents the share of earnings that the company aims to distribute as dividends to shareholders over a long-term. One such model on these lines of gradual adjustment is the target payout ratio adjustment model. Under this model, if the earnings of the company are expected to rise and the current dividend payout ratio is below the target dividend payout ratio, the investor can calculate the estimated future dividends as follows:
Expected Dividend = (Previous Dividend) + [(Expected Increase in EPS) * (Target Payout Ratio) * (Adjustment Factor)]
Where adjustment factor = 1/ number of years over which the dividends adjustments will happen.
Constant Dividend Policy
Under the constant dividend policy, a specific percentage of the company’s earnings is paid out as dividends every year. The short-term earnings’ volatility affects the dividends in this case and hence, the amount of dividends varies directly with the company’s earnings. However, this policy is not used very frequently in companies.
Residual Dividend Policy
Under the residual dividend policy, the company pays the dividends from the funds left after the finances for the capital expenditures of the current period are deducted from the internally generated funds of the company. This policy takes the company’s investment opportunity schedule, target capital structure and the cost of capital raised externally into consideration.
The following steps determine the payout ratio to be implemented:
- The optimal capital budget is identified.
- The equity required to finance the identified capital budget under a given capital structure is determined.
- Retained earnings are used to the maximum extent possible to meet the requirements of equity.
- Dividends are paid from the residual earnings available after the requirements of the optimal capital budget are met.
Residual dividend policy has the following advantages:
- This model is very simple to use. The company utilizes the funds for profitable projects and then distributes the remaining to the shareholders.
- The management is free to pursue profitable opportunities without worrying about the dividend constraints.
However, there are a few disadvantages as well:
- The dividend payments are highly volatile as they fluctuate with the available investment opportunities.
- The investors may demand a higher rate of return on their equity because of the ambiguity about future dividends. It may also result in a lower valuation.
The payout policy of a company may have a provision of share repurchases along with dividend payments. Under a share repurchase, the company buys back its own shares from the shareholders. Since the company pays its own cash to buy back shares, this transaction is considered as a good alternative to cash dividends.
Cash Dividends versus Repurchasing Shares
The rationale for repurchasing shares versus cash dividends is as follows:
- Possible Tax Advantages: When the tax rates on dividend income are higher than those on capital gains, people prefer share repurchases to cash dividends as share repurchase has a tax advantage.
- Support for the Stock Price: When a company buys back its own shares, it sends a signal to the market that their stock is a good investment. Such signaling is important when there is asymmetric information present in the market. This is often used by the company when its share price is on a declining spree and it wants to signal the positive future outlook to the investors.
- Flexibility: Share repurchases give a lot of flexibility to the company with respect to dividend decisions. There is no need for the company to commit to sharing repurchases for the long term. Hence, it can use this as a supplement to regular dividends to implement the residual dividend policy. Moreover, the share repurchases can be market timed for the best results.
- Offsetting Dilution: Employee stock options often dilute the EPS of the company when exercised. Share repurchases reduce this dilution.
- Financial Leverage: Share repurchases increase the leverage of the company. The management of the company can change the capital structure of the company by reducing the percentage of equity.
Conclusion: Dividend policy is an important factor in the valuation of the company. Moreover, the signals interpreted by the investors from the various changes in the dividend payments also affect the stock price of the company. It is important for the analyst to know the impact of various dividend policies and the share repurchases on the stock and its valuation.1,2