One of the most critical decisions taken by the board is determining the accurate amount of dividend payable. Dividends are a very important link between the shareholders and the company. Dividends constitute one of the few channels for the flow of wealth between the two parties, viz., companies and investors. For a number of reasons, companies are expected to be very precise when they calculate dividends. Even a small oversight while calculating dividends could gravely affect the reputation of the company, its valuation, shareholders’ trust, and even creditworthiness.
How do Companies Determine Dividend?
A single textbook formula that the company uses to calculate dividends does not exist. The combined efforts of a team of financial experts and members of the board determine the best-fit dividend policy. It is also important to note that every company operates in diverse environments and therefore chases different objects. For the same reason, one may notice wide differences between how two companies calculate dividends.
- How do Companies Determine Dividend?
- Importance of Accurate Determination of Dividends
Approaches to Determine Dividends?
Below are some technical approaches that companies may adopt depending on their goal.
Dividend Yield Method
The dividend yield method compares the dividend against the stock price of the company. The company may resort to this method when it may want to expand its shareholder base, i.e., increase market capitalization. Also, it is the most useful method when the company’s goal is the maximization of shareholder satisfaction. The firm may pass on the benefits of higher profitability by declaring dividends at a higher rate.
The company may set a target yield rate that it may want to provide to the shareholders. Based on these criteria, it may proceed to determine the actual dividend payout.
|Dividend Yield = (Dividend Per Share/Market Price Per Share)*100|
For example, Orange Computers is trading at a value of USD 500 per stock (Nominal Value of USD 100). The company may decide to provide a yield of 15% to its shareholders. Therefore, the company may arrive at the dividend figure through backward calculations. The yield will be 15% when the dividend per share is USD 75 (15% of USD 500). Therefore the company will declare the dividend at the rate of 75% (75/100 * 100%) being a percentage of nominal value.
Dividend Discount Model & Perpetuity
One of the most fundamental concepts of finance is that the value of any asset is equivalent to the present value of cash flows. Applying the same principle, the company’s valuation is the present value of the dividends it pays, assuming a constant growth rate.
This method may be adopted by companies who are aiming to achieve a healthy valuation by improving their stock prices. A good valuation makes the company more viable and attractive to the stakeholders and makes it easier to raise funds. This approach is also suitable for companies who are preparing themselves for a buy-out. Initiating a healthy stream of dividends will help in jacking up the valuations. This enables the company to fetch a healthy price when it goes on the floors for sale.
Growth & Retention Ratio
Companies that are capital-intensive, such as tech, do not maintain a steady payout. To carry out even their most basic operations, they are required to plow back a major chunk of their earnings. Therefore, such heavy infrastructure-oriented companies aim to deliver value to their shareholders through a rapid increase in stock prices. Shareholders of such companies mainly invest, expecting greater capital appreciation rather than dividends. These companies may, therefore, pay very less to no dividends. Maintaining a steady growth rate is the singular priority for these companies.
Growth (g) = b * r
- b = Total Earnings
- r = Retention Ratio
Since growth is a direct function of retained earnings, such companies lay great emphasis on plowing back. They have a target growth ratio in mind, which must be maintained. Therefore, the company must re-invest a predetermined portion of earnings to maintain the growth rate. The company may, at its discretion, choose to pay out as the dividend the portion of the earnings over and above the minimum required.
Importance of Accurate Determination of Dividends
The manner in which an organization calculates dividends speaks a lot about its intentions. It is possible to get an idea of the financial health, expansion plans, and management attitude solely from its dividend policy. Therefore, it becomes compelling for the management to calculate dividends in a manner that fosters a robust and sustainable image.
Below are some of the factors which guide the management’s decision-making process:
Cash Surplus Available with the Company
This is the first and most important consideration of the dividend calculation policy of the company. A dividend, once declared, becomes a liability. No matter what, the company is then bound to pay it. Therefore, the board must carefully examine the adequacy of the cash balance with the company. It must ensure that the company will still be holding sufficient cash even after the payout of dividends. Maintenance of liquidity is fundamental to ensure that the operations are carried on smoothly. The creditors are also required to be kept unthreatened from fluctuating cash balances.
It is of paramount significance to consider the opportunity cost of funds with the company. It may not be wise for a company in its expansion phase to pour out huge amounts of cash in the form of dividends. Giving such funds as dividends implies that the company is letting go of an attractive investment opportunity. Even the shareholders would expect their company to do justice to them by redirecting funds to the most lucrative ventures, even if it means a low dividend payout in the short run.
Shareholder Expectation and Valuation
A company operates in a market that is run by the forces of demand and supply. It is essentially the market sentiment and shareholder perception that ultimately determine the company’s valuation. Therefore, the company must gauge shareholder expectation while framing its plan to calculate dividends. Shareholder presumptions are based on historical patterns of the company to declare dividends. The investors may not welcome a sudden deviation from the company’s usual practice of dividend declaration.
Another important macroeconomic consideration is how the industry calculates dividends. Investors normally have uniform expectations from all companies belonging to a particular industry. A company that comes across as an exception to the rule and follows significantly separate methods to calculate dividends may smell fishy to the shareholders. Such companies may also find it difficult to raise funds from the capital market. Therefore, a company must also adhere to factors external to itself if it wants to continue profitably in the industry.