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What is a 'Dividend Policy'

A dividend policy is the policy a company uses to decide how much it will pay out to shareholders in the form of dividends. Some research and economic logic suggests that dividend policy may be irrelevant (in theory), but many investors rely on dividends as a vital source of income.

BREAKING DOWN 'Dividend Policy'

Because dividends represent a form of income for investors, a company's dividend policy is an important consideration for some investors. As such, it is an important consideration for company leadership, especially because 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

The stable dividend policy is the easiest and most commonly used policy. The goal of the policy is to aim for steady and predictable dividend payouts every year, which is what most investors are seeking. When earnings are up, investors receive a dividend. 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 allows the shareholder to have more certainty around the amount and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that, in booming 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 when dividend income is highly volatile.

Residual Dividend Policy

A residual dividend policy is also highly volatile, but for some investors, it is the only acceptable dividend policy that a company should have. In a residual dividend policy the company pays out what's left after it pays for capital expenditures and working capital needs. This approach is volatile, but it makes the most sense in terms of business operations. Investors don't want to invest in a company that justifies its increased debt with the need to pay dividends.

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