The main goal of investing in stocks is to earn a return, which investors can receive either through capital appreciation or dividends. For companies, this raises an important question: how much profit should be paid out as dividends, and how much should be retained to fund future growth?
In this blog, we will give you a detailed overview of dividend policies along with their types and factors affecting them.
What is a Dividend?
A dividend is a financial reward received by the shareholders of the company. It is distributed out of the company’s profit. The decision to pay the dividend is made by the company’s board of directors. Dividends are declared per share; thus, an investor’s total dividend equals the per-share dividend multiplied by the number of shares they own.
Meaning of Dividend Policy
Dividend policy is a strategy or policy used by the company to distribute its profit to its shareholders in the form of dividends. The profits earned by the company are generally shared either in cash or in the form of stocks. The decision to distribute the dividend made by the company is very crucial as it has to maintain the balance between the amount to be distributed among shareholders and the amount to retain in business for further expansion.
Example
Let’s understand the dividend policy of a company through an example. A company named ABC Limited earns a profit of INR 10,00,000 in a financial year, and the total number of outstanding shares is 1,00,000. And the board of directors has decided in a meeting that they want to distribute at least 30% of the total profit in the form of dividends to their shareholders. Which means the amount of profit which will be distributed as a form of dividend will be 30% of 10,00,000, which comes around 3,00,000. Now, the dividend payout according to the company policy is INR 3 per share.
And the remaining profit amount of 7,00,000, which was not distributed as a dividend, will be used by the company in their further expansion plans.
Read Also: What Is Dividend Yield? Definition, Formula, and Investment Insights
Types of Dividend Policy
The types of dividend policies used by companies are as follows:
1. Fixed Dividend Policy
Under this method, the company pays a fixed amount of dividend to their shareholders every year, irrespective of the profit. Which means if the company’s earnings are reduced in any year, it will still give a fixed amount of dividend. On the other hand, if the company’s profit is increased in a year, it still declares the same amount of dividend and its dividend will not increase. Generally, companies aim to maintain a fixed dividend, but extreme profit losses may lead to reductions.
2. Constant Dividend
In this, a fixed percentage of the company’s profit is declared as a dividend. In the constant dividend policy, the dividend will be increased with the increase in the profit of the company. Suppose the company decides that it will distribute 10% of its earnings as dividends, then the dividend earned by the investor depends on the earnings of the company.
3. Residual Dividend
Residual dividends depend on the company’s capital budgeting requirements, meaning dividends are paid from leftover profits after financing profitable investment opportunities.
4. Zero Dividend
Under a zero dividend policy, the company reinvests the entire amount of profit in the business, with an objective to fulfil its growth plans and expansion initiatives.
Factors Affecting Dividend Policy
The key factors that affect the dividend policy are as follows:
- Profitability: The company’s profit is the key factor on which the company declares its dividend. The higher the profit the higher the dividend.
- Earning Stability: Companies with a stable earnings track record tend to follow a stable dividend policy compared to companies with irregular earnings.
- Debt Level: The companies with a higher debt level tend to declare low dividends, as a major portion of their earnings is utilised towards debt repayment.
- Future Plan: If the company is primarily focusing on its expansion and growth, then it might use a larger portion of its profit towards funding plans instead of distributing it as a dividend.
- Industry: There are various industries which are capital-intensive; they generally do not declare dividends. However, certain companies in sectors like FMCG, OMCs regularly declare dividends.
- Holding Pattern: The Company’s shareholding pattern is also another key factor in determining the dividend. If the promoters’ stakes are high, they generally depend on dividends as an income source.
Importance of Dividend Policy
The importance of dividend policy is as follows:
- Reputation: Companies which regularly declare dividends are considered trustworthy among investors and are preferred by investors who seek regular income.
- Financial Strength: Companies which have strong profitability and cash flow generally declare dividends, hence increasing investors’ confidence.
- Attracts Investors: Conservative and retirement investors tend to prefer dividend-oriented companies instead of growth-oriented companies, as they look for regular dividends.
- Capital Structure: The dividend policy of the company impacts the capital structure decisions. A higher proportion of profits declared as dividends may require the company to raise debt to fund upcoming projects.
- Expectation of Shareholders: The Dividend policy of a company helps an investor in deciding whether to hold or invest in a particular share or not.
Read Also: Top 10 Highest Dividend Paying Penny Stocks in India
Conclusion
On a concluding note, the dividend policy of a company plays a vital role in managing the company’s financial, capital structure, and its commitment towards its shareholders. Balancing dividend payouts with funds retained for future growth is like walking a tightrope. If a company declares a significant portion of its earnings as dividends, then it might lose future growth opportunities. However, it is advisable to consult your investment advisor before investing.
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Frequently Asked Questions (FAQs)
What is a dividend policy?
A dividend policy of a company refers to the strategy of deciding the amount to be declared as a dividend out of profit.
Can a company change its dividend policy anytime?
Yes, a company’s board of directors has the authority to change the policy related to dividend declaration at any point in time.
How are dividends taxed in India?
In India, dividends declared by the companies are taxed as per the applicable income tax slab rate of the investors.
Is it mandatory for all companies to declare a dividend?
No, it is not mandatory for the companies to declare a dividend; they can declare it based on the profit earned by them in a financial year.
What is the interim dividend?
When a company declares a dividend in the middle of a year, it is known as an interim dividend.
