A dividend policy is a set of guidelines that a company follows to decide how much of its earnings it will pay out to shareholders. There are four main types of dividend policy: constant, progressive, target payout and residual.
A constant dividend policy means that the company pays a fixed amount of dividend per share every year, regardless of its earnings or market conditions. This policy signals stability and confidence to investors, but it may also limit the company's ability to invest in growth opportunities or cope with financial distress.
A progressive dividend policy means that the company increases its dividend per share every year at a steady rate, usually in line with inflation or earnings growth. This policy also signals stability and confidence to investors, but it allows the company to retain some earnings for reinvestment or debt reduction.
A target payout dividend policy means that the company pays a certain percentage of its earnings as dividends every year, adjusting the amount of dividend per share according to its profitability. This policy aligns the interests of shareholders and managers, as both benefit from higher earnings and dividends. However, this policy may also result in volatile dividends that depend on the business cycle and market conditions.
A residual dividend policy means that the company pays dividends only after meeting its capital budgeting and financing needs. This policy implies that dividends are a residual or leftover payment to shareholders, after investing in all positive net present value projects and maintaining an optimal capital structure. This policy maximizes the value of the firm, but it may also disappoint investors who prefer stable and predictable dividends.
One more term that dividend investors should be familiar with is the ex-dividend date. This is the date before which an investor must buy a share in order to receive a particular dividend. For example, if a company declares a dividend on March 1 with an ex-dividend date of March 15 and a payment date of March 31, an investor must buy the share before March 15 to receive the dividend on March 31. If an investor buys the share on or after March 15, they will not receive the dividend until the next payment date.
To summarise, dividends are an important aspect of value investing that can provide income and stability to shareholders. By understanding some key concepts such as dividend yield, payout ratio, and ex-dividend date, investors can better evaluate a company's dividend policy and its financial health and performance.