Dividends are a portion of a company’s earnings paid to eligible share owners per share basis. So, if you own a share in a company that has declared a dividend, you’ll receive a dividend payment for each share. You can generate investment income by investing in individual shares that pay dividends and dividend-paying funds, like many mutual funds or ETFs. While dividends can play a role in a diversified, fixed-income portfolio, dividend declaration is not guaranteed, and even if declared, the amount may fluctuate year on year.
A dividend policy lays out what percentage of a company’s earnings would be paid to its shareholders. For example, a company may have the policy to pay 50% of its earnings out as dividends each year. So if the company earned INR 1 Cr in a given year, it would pay INR 50 Lakhs in dividends. There are three significant types of dividend policies.
Three Major Types of Dividend Policies
- Residual Dividend Policy
- Stable Dividend Policy
- Hybrid Dividend Policy
All the dividend policies mentioned above have their advantages and disadvantages. A residual approach allows the company to maintain a specific preferred capital structure (i.e., debt/equity). In contrast, a stable dividend policy, as the name implies, tends to declare consistent yearly dividends. A hybrid approach mixes the priorities of the residual and stability policies, allowing a company to have a more flexible debt/equity ratio to set a more stable dividend payout rate.
Types of Dividends
Usually, dividends are paid out on a company’s ordinary share. However, a company can pay out several types of dividends to its shareholders.
This is the most common type of dividend. Companies generally pay these dividends in cash and directly into the shareholder’s bank account.
Instead of paying cash, companies can also pay dividends in the form of shares. This will increase the number of shares issued by a company and with a shareholder. The market price of a share might get reduced after the declaration of a share dividend.
Dividend Reinvestment Program (DRIP)
Investors participating in a DRIP can reinvest dividends into the company’s share, often at a discount, i.e., at a price lesser than the prevailing market price.
These dividends payout on all shares of a company’s ordinary share but don’t recur like regular dividends. Instead, a company often issues a special bonus by distributing profits accumulated over several years, for which it has no immediate need.
Payouts are issued to owners of preferred shares. A preferred share is a type of share that functions less like a share and more like a bond. Unlike dividends on ordinary stock, dividends on preferred shares are generally fixed.
Why do Companies Pay Dividends?
Dividends can help companies build trust with shareholders since they’re a positive sign of financial health, demonstrating that the company has the means to share earnings with investors instead of putting it back into the business. In addition, it has been seen that well-established companies are more likely to pay dividends than less mature, high-growth ones (like startups) that rely on reinvesting capital. This creates confidence in investors and the market.
Which Companies Issue High Dividends?
The dividend amount may differ from one company to another. For example, companies with a mature status, i.e., those that have been around for a long time, usually make big, predictable profits and are likelier to pay out profits in the form of dividends.
Examples of these types of companies include:
- Oil and gas companies,
- Banks and financial institutions (BFSI),
- Pharmaceutical companies,
- Fast Moving Consumer Good Companies (FMCG),
- Utility companies.
New startups and companies that experience strong growth often issue no or little dividend. These companies often face high costs or even losses. This type of company prefers to invest its money in new projects and developments to create more future value for its shareholders.
As a shareholder, there are two ways to benefit from shares: a dividend and an increase in share price. When a company smartly reinvests its profits, it can help the profitability and overall growth of the company. In that case, nevertheless, the return on new investments must be higher than the return achieved by simply repurchasing their shares.
Why Invest in Dividend Shares?
While some think of dividends as a way for retirees to use the market as a source of income, dividend shares can be a valuable asset for all investors to consider. Dividends are an additional way to profit in the share market besides relying on capital gains since they could be reinvested manually or through a dividend reinvestment program (DRIP) – to further expand your position in the market.
Conclusion: Dividend is an Important Market Signal
A company will treat its dividend decisions as an active part of its strategy when its management believes that the payment or nonpayment of a dividend provides information to the market. This is called financial signaling because the dividend paid by the company sends a signal to investors about the company’s profitability. Conversely, in a situation where the belief is that a dividend does not influence the market, the company will not actively create a dividend policy.
A company’s dividend policy should be one that will maximize the wealth of its shareholders.