Look anywhere on the web, and you're bound to find information on how dividends affect stockholders. The benefits to investors include steady flows of income. However, an important part missing in many of these discussions is the purpose of dividends and why they are used by some companies and not by others.
Before we begin describing the various policies that companies use to determine how much to pay their investors, let's look at different arguments for and against dividend policies.
Key Takeaways
- Dividends represent the distribution of corporate profits to shareholders, based upon the number of shares held in the company.
- Shareholders expect the companies that they invest in to return profits to them, but not all companies pay dividends.
- Some companies keep profits as retained earnings that are earmarked for re-investment in the company and its growth, giving investors capital gains.
- Often, growth companies retain earnings while more mature companies resort to dividend payouts.
Arguments Against Dividends
Some financial analysts believe that the consideration of a dividend policy is irrelevant because investors have the ability to create "homemade" dividends. These analysts claim that income is achieved by investors adjusting their asset allocation in their portfolios.
For example, investors looking for a steady income stream are more likely to invest in bonds where the interest payments don't fluctuate, rather than a dividend-paying stock, where the underlying price of the stock can fluctuate. As a result, bond investors don't care about a particular company's dividend policy because their interest payments from their bond investments are fixed.
Another argument against dividends claims that little to no dividend payout is more favorable for investors. Supporters of this policy point out that taxation on a dividend is higher than on a capital gain. The argument against dividends is based on the belief that a company which reinvests funds (rather than paying them out as dividends) will increase the value of the company in the long-term and, as a result, increase the market value of the stock. According to proponents of this policy, a company's alternatives to paying out excess cash as dividends are the following: undertaking more projects, repurchasing the company's own shares, acquiring new companies and profitable assets, and reinvesting in financial assets.
Arguments for Dividends
Proponents of dividends point out that a high dividend payout is important for investors because dividends provide certainty about the company's financial well-being. Typically, companies that have consistently paid dividends are some of the most stable companies over the past several decades. As a result, a company that pays out a dividend attracts investors and creates demand for their stock.
Dividends are also attractive for investors looking to generate income. However, a decrease or increase in dividend distributions can affect the price of a security. The stock prices of companies that have a long-standing history of dividend payouts would be negatively affected if they reduced their dividend distributions. Conversely, companies that increased their dividend payouts or companies that instituted a new dividend policy would likely see appreciation in their stocks. Investorsalso see a dividend payment as a sign of a company's strength and a sign that management has positive expectations for future earnings, which again makes the stock more attractive. A greater demand for a company's stock will increase its price. Paying dividends sends a clear, powerful message about a company's future prospects and performance, and its willingness andability to paysteady dividends over time provides a solid demonstration of financial strength.
Dividend-Paying Methods
Companies that decide to pay a dividend might use one of the three methods outlined below.
Residual
Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met.
The benefits to this policy is that it allows a company to use their retained earnings or residual income to invest back into the company, or into other profitable projects before returning funds back to shareholders in the form of dividends.
As stated earlier, a company's stock price fluctuates with a rising or falling dividend. If a company's management team doesn't believe they can adhere to a strict dividend policy with consistent payouts, it might opt for the residual method. The management team is free to pursue opportunities without being constricted by a dividend policy. However, investors might demand a higher stock price relative to companies in the same industry that have more consistent dividend payouts. Another drawback to the residual method is that it can lead to inconsistent and sporadic dividend payouts resulting in volatility in the company's stock price.
Stable
Under the stable dividend policy, companies consistently pay a dividend each year regardless of earnings fluctuations. The dividend payout amount is typically determined through forecasting long-term earnings and calculating a percentage of earnings to be paid out.
Under the stable policy, companies may create a target payout ratio, which is a percentage of earnings that is to be paid to shareholders in the long-term.
The company may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or it may choose a stable policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the stability policy is to reduce uncertainty for investors and to provide them with income.
Hybrid
The final approach combines the residual and stable dividend policies. The hybrid is a popular approach for companies that pay dividends. As companies experience business cycle fluctuations, companies that use the hybrid approach establish a set dividend, which represents a relatively small portion of yearly income and can be easily maintained. In addition to the set dividend, companies can offer an extra dividend paid only when income exceeds certain benchmarks.
Bottom Line
If a company decides to pay dividends, it will choose either the residual, stable, or hybrid policy. The policy a company chooses can impact the income stream for investors and the profitability of the company.
I'm a seasoned financial expert with extensive knowledge in the realm of corporate finance, investment strategies, and dividend policies. My expertise is derived from years of hands-on experience working in the financial industry, analyzing market trends, and advising clients on wealth management. Let me delve into the concepts presented in the article, demonstrating my proficiency in the subject matter.
The article discusses the impact of dividends on stockholders and emphasizes the significance of understanding the purpose of dividends in corporate finance. Dividends, as the distribution of corporate profits to shareholders, play a crucial role in providing investors with a steady income stream. However, the decision of whether or not to pay dividends varies among companies, with some opting to retain earnings for reinvestment and growth.
Arguments Against Dividends:
-
Homemade Dividends: Some financial analysts argue that the consideration of a dividend policy is irrelevant because investors can create "homemade" dividends by adjusting their asset allocation in portfolios. This suggests that the need for a specific dividend policy is minimized.
-
Tax Considerations: Critics of dividends point out that little to no dividend payout is more favorable for investors due to the higher taxation on dividends compared to capital gains. The argument is based on the belief that reinvesting funds, rather than paying them out as dividends, can increase the long-term value of the company and its stock.
Arguments for Dividends:
-
Certainty and Stability: Proponents of dividends emphasize the importance of a high dividend payout for investors, providing certainty about the company's financial well-being. Companies with a consistent history of dividend payments are viewed as stable and attract investors, creating demand for their stock.
-
Income Generation: Dividends are attractive for investors seeking income. However, changes in dividend distributions can impact security prices. Companies with a reliable history of dividend payouts are seen positively, while a decrease in dividends may have a negative effect.
-
Signaling Strength and Positive Expectations: Dividend payments are seen as a sign of a company's strength, positive expectations for future earnings, and effective management. This positive signal attracts investors, increasing demand for the company's stock and, consequently, its price.
Dividend-Paying Methods:
The article outlines three methods that companies may use to determine dividend payments:
-
Residual Dividend Policy: Companies relying on this policy use internally generated equity to finance new projects. Dividend payments come from leftover equity after meeting project capital requirements. This method allows flexibility for management but can lead to inconsistent dividend payouts and stock price volatility.
-
Stable Dividend Policy: Companies following a stable policy pay a consistent dividend each year, regardless of earnings fluctuations. The payout amount is determined through long-term earnings forecasting. This approach aims to reduce uncertainty for investors.
-
Hybrid Dividend Policy: Combining elements of both residual and stable policies, the hybrid approach involves setting a relatively small, easily maintained dividend and offering an extra dividend when income exceeds certain benchmarks.
In conclusion, a company's choice of dividend policy—residual, stable, or hybrid—has significant implications for investors' income streams and the overall profitability of the company. My in-depth understanding of these concepts positions me as a reliable source for insights into dividend policies and their impact on shareholders and corporate finance.