Key Takeaways
- Dividends are payments stockholders receive from the company they own stock in, and these payments represent a small part of the profit the company has earned.
- Dividends can be distributed in cash or stock, and companies follow various dividend policies to determine their payouts.
- Established, mature companies tend to offer higher and more stable dividends than growth-oriented or early-stage companies because mature firms typically have stable earnings and fewer investment opportunities, allowing them to return more cash to shareholders.
What Is a Dividend?
A dividend, or stockholders’ dividend, is a payment made by a company to its owners and stockholders. The dividend payment represents a portion of the company’s current net earnings, but special dividend payments, funded with retained earnings or asset sales, are sometimes made.
Well-established companies typically pay higher dividends than early-stage companies, as mature firms tend to have more stable, predictable earnings and fewer investment opportunities than growth-oriented companies. As a result, established firms often return more cash to their stockholders in the form of dividends.
Most companies pay dividends once per quarter, but the frequency can vary. Some companies pay a monthly dividend, while others pay an annual dividend. Others pay no regular dividend at all.
Ultimately, the amount and frequency of dividend payments is determined by the company’s board of directors.
Types of Dividends
The vast majority of dividend distributions are made in cash. However, a company may sometimes pay a stock dividend to its shareholders. Rather than a cash payout, a stock dividend involves the issuance of additional shares of stock.
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How Are Dividends Determined?
The determination of a dividend is unique to the company who is paying it. Deciding on the amount of a dividend is a big strategic decision for a company, given the focus many investors put on the amount of income produced by their investments.
As a result, most companies plan, communicate and initiate their dividend distributions in line with a well-structured dividend policy. At a minimum, the policy outlines the amount of future dividend payments and their frequency.
The three primary types of dividend policies are outlined below.
Stable Dividend Policy
A stable dividend policy is the most common and easiest to administer. The objective is to pay a steady and predictable dividend over time, regardless of earnings volatility.
Dividend increases or decreases are aligned with the long-term growth trajectory of the company, not quarter-to-quarter earnings fluctuations. Ultimately, this type of plan gives stockholders a high degree of confidence in the amount and timing of future dividends.
Constant Dividend Policy
With a constant dividend policy, the company pays out a certain percentage of its earnings every period. If earnings are up, investors get a larger dividend; if earnings are down, investors get a smaller dividend — or perhaps no dividend at all.
The main drawback with this type of policy is the potentially volatile nature of the dividend, which can make it difficult for those investing to plan cash flow.
Residual Dividend Policy
With a residual dividend policy, a company prioritizes the reinvestment of cash flow over dividend payouts, meaning that the company only pays dividends if it has earnings left over after making investments in capital expenditures and working capital.
At a high level, this process works as follows:
- An example company has net earnings of $100 million.
- The company’s investments in capital expenditures and working capital total $85 million.
- Subtracting capital expenditures and working capital investments from net earnings, this leaves $15 million available for dividend distributions ($100M – $85M = $15M).
A residual dividend policy has the potential to be more volatile than the other types of dividend policies. Nevertheless, many companies and stockholders favor this type of arrangement due to its focus on the creation of long-term economic value.
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Example of a Cash Dividend
Let’s look at an example scenario from the stockholder’s perspective, as you may encounter a situation similar to this one while evaluating your own personal finance situation. Assume the following:
- You own 1,000 shares of Company XYZ stock, which is currently priced at $200 per share.
- Earnings per share (EPS) totaled $7 for the quarter.
- Company XYZ maintains a stable dividend policy with quarterly distributions.
- Long-term growth projections support a quarterly dividend payment of 40 percent of earnings.
Based on the information above, you as a stockholder can expect the following quarterly dividend payment:
Quarterly Dividend Payment = Number of Shares Owned × EPS × Dividend Payout Ratio
Quarterly Dividend Payment = 1,000 × $7 × .40 = $2,800
Annualized, this produces the dividend yield computed below.
Dividend Yield = (Quarterly Dividend Payment ÷ Number of Shares Owned × 4) ÷ Stock Price
Dividend Yield = ($2,800 ÷ 1,000 × 4) ÷ $200 = 5.6%
Closing Thoughts
Dividends are just one aspect of a stock’s worth. The potential for stock price appreciation is often a much larger determinant of value. Smart investors are aware of this and base their investment decisions on the complete picture, not just the size of a dividend payment.
That said, dividends are very important to income-focused investors and especially important to retirees, who often rely on the income to live. For these investors, tracking the consistency of a company’s dividend over time is a smart way to assess the reliability of the income.
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