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What is 'Dividend Policy'?

Dividend policy is the policy a company uses to structure its dividend payout to shareholders. Some researchers suggest that dividend policy may be irrelevant (in theory) because investors can sell a portion of their shares or portfolio if they need funds. This is called the "dividend irrelevance theory," and it infers that dividend payouts have minimal impact on stock price. 

BREAKING DOWN 'Dividend Policy'

Despite the suggestion that dividend policy is irrelevant, it is a form of income for shareholders. Company leaders are often the largest shareholders and have the most to gain from a generous dividend policy. Most companies view a dividend policy as an integral part of the corporate strategy. Management must decide on the dividend amount, timing and various other factors that influence dividend payments over time. There are three types of dividend policies: a stable dividend policy, a constant dividend policy and a residual dividend policy.

Stable Dividend Policy

Stable dividend policy is the easiest and most commonly used. The goal of the policy is steady and predictable dividend payouts each year, which is what most investors seek. When earnings are up, investors receive a dividend, and when earnings are down, investors receive a dividend. The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach gives the shareholder more certainty concerning the amount and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that, in boom years, investors may not see a dividend increase. By contrast, under the constant dividend policy, a percentage of the company's earnings are paid every year. In this way, investors experience the full volatility of company earnings. If earnings are up, investors get a larger dividend; if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially when dividend income is highly volatile.

Residual Dividend Policy

Residual dividend policy is also highly volatile, but for some investors, it is the only acceptable dividend policy. With a residual dividend policy, the company pays out what dividends remain after the company has paid for capital expenditures and working capital. This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends.

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