A business with a stable dividend policy pays out a steady dividend every given period, regardless of the volatility in the market. The exact amount of dividends that are paid out depends on the long-term earnings of the company. The dividend’s growth is in line with the company’s long-term earnings.
Under a stable dividend policy, it is common for companies to distribute dividends every quarter, with the payout in line with the quarterly earnings of the company. However, it can also be paid out annually or semi-annually. The stable dividend policy is one of the most popular policies because the company’s volatility is not reflected in the dividend payout. Shareholders can be certain that they will receive a dividend payment at least once a year.
Dividends and Dividend Policies
A dividend is a reward that a company gives to its shareholders for investing in the company. The dividends can be distributed in many different ways, such as cash payment or through stock shares. The board of directors of a company decides how much of a dividend to give out and how to time the redistribution of profits.
One of the most important decisions made by the shareholders in the company is the dividend policy they need to follow. At the highest level, a company faces two decisions: retain profits or distribute them to the shareholders. Sometimes, the company may choose to retain the profits in the company for a variety of reasons, such as potential investment opportunities for the company, future earnings, flotation costs, tax liabilities, or other considerations that restrict the company from paying out a dividend.
After the company makes a decision on what they should do with the profits, the next step is to create the dividend policy. The dividend policy acts as a tool for the company to attract investors and receive preferential treatment in the financial markets. The investors’ preferences also play a key role in deciding the type of dividend policy to use.
The tax policy of the country also determines if the shareholder would want to receive the stock in cash or as stock repurchase options.
Implementation of the Stable Dividend Policy
1. Constant payout ratio
This is when a certain specified percentage of the company’s earnings is distributed to shareholders as dividends. Many companies prefer the constant payout policy as it makes it easier for management to decide how much of the earnings should be retained.
2. Constant dividend per share
The company distributes a fixed amount of cash dividends. It creates a reserve that allows them to pay a fixed dividend even when earnings are low or there are losses. The constant dividend policy is more suited for companies whose earnings remain stable over a number of years.
3. Combination of the two policies
Under a combination of the policies, the company distributes a fixed amount of regular dividend in addition to an extra dividend that is paid in line with its earnings. The combination policy allows the management to be flexible and is a good option for companies whose earnings constantly fluctuate.
Stable Dividend Policy and Target Payout Ratio
The stable dividend policy can also be defined by the target payout ratio. The target payout ratio represents the percentage of earnings that the company chooses to distribute to shareholders in the long term. As per the model, the earnings of the company are expected to rise if the dividend payout ratio is below the target dividend payout ratio. An investor can calculate the estimated future dividend as follows:
Expected Future Dividend = Current Dividend + (Expected Increase in EPS x Target Payout Ratio x Adjustment Factor)
Adjustment Factor is the number of years over which dividend adjustments will happen
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