Assume that a corporation has $1 million left over after paying all of its expenses, such as operating costs, interest payments, income taxes, and preferred share dividends. The board of directors now has to decide what to do with these earnings and it has a couple of options. It can choose to either retain the earnings within the corporation or pay common share dividends. They could, of course, choose some combination of both. It I s important to keep in mind that either option ultimately benefits the common shareholder. If the company decides to pay a dividend, the common shareholders would surely be happy to receive the cash. On the other hand, if the corporation retains the earnings within the business, presumably to fund future growth, the company’s share price will likely increase.
So what type of dividend policy do you think an investor would prefer? Well, it all depends on the investor’s objectives. Different dividend payout policies are attractive to different types of investors. If the investor’s primary objective is income, then a dividend payout policy that leans towards paying much of the earnings out to shareholders would be ideal. On the other hand, if the investor’s primary objective is growth, then a dividend payout policy that focuses on plowing profits back into the business to fund future growth would be preferred.
A company’s dividend payout ratio is calculated using the following formula.
For example, if the company has earnings of $1.00 per common share and pays a dividend of $0.10 per common share, it’s payout ratio would be 10% ($0.10 / $1.00).
When determining the dividend payout policy, a company’s board of directors considers the business’s needs and opportunities, and will ultimately have to answer these questions:
- Will the company use some or all of the profits to buy back its own shares, and therefore reduce the number of common shares outstanding in the marketplace?
- Will the company retain some or all of the earnings within the business?
- Will the company pay some or all of the earnings out as common share dividends? And if the company does pay dividends, what will the dividend payout ratio be?
As mentioned earlier, paying common share dividends and retaining earnings within the company both benefit the common shareholders. But if a company has been paying dividends, it will generally try to keep those dividends somewhat consistent. Investors can become accustomed to receiving a dividend and they do not like surprises. An elimination or reduction of a dividend could cause the share price to decline. So, to help manage shareholder expectations, dividends can be classified as either “regular” or “extra”.
Regular dividends are the amount an investor can expect to receive on an ongoing basis unless the corporation suffers a significant reduction in earnings. For example, the policy could be to pay a quarterly dividend of $0.25 per share barring unforeseen circumstances. Extra dividends are those that are paid in extra-ordinary circumstances, which may not reoccur in the future. For instance, if a company has sold off a subsidiary and found itself flush with cash, it may elect to pay an extra dividend that year. Now keep in mind, no dividends, even regular dividends, are guaranteed!
Finally, let’s discuss the difference between a cash dividend and a stock dividend. Which one do you think would have no impact on a company’s working capital? Well, a cash dividend is obviously paid in cash. This means that the investors receive cash, and the company’s cash on hand (i.e. its working capital) would have to go down. But if a company does not want to reduce its working capital, but still wants to pay a dividend, it could elect to pay a stock dividend in lieu of cash. For example, instead of paying a $0.10 per share cash dividend, it could elect to give some fraction of a common share for each common share held. There is a downside of course; even though paying a stock dividend does not reduce the company’s working capital, it does dilute the company’s earnings per share.