Dividend policies: what you need to know
Understanding dividends is crucial for any investor. We explain dividends, the different types of policies companies adopt, and how to analyse the performance of a stock’s dividend.
What is a dividend?
A dividend is money that is regularly paid by a business to its shareholders using profits, cash reserves or even debt. Dividends can be paid every quarter, at the end of each half of the financial year, or annually, and are paid on a per share basis. Dividend payments are regarded as rewards for investors that have put money into the business to help it grow.
If companies pay more than one dividend each year then it may be weighted. For example, a stock may pay one-third of its total dividend for the full year (FY) at the end of H1 and the other two-thirds as a final payment at the end of the financial year.
The majority of dividend payments are made to shareholders in cash, but they can be made in other ways, such as issuing new stock to investors.
What is a dividend policy?
A dividend policy dictates how much cash is returned to shareholders. When deciding what dividend to pay, if any, a company must look at the profits it has made and weigh up how much should be retained in the business to fund future growth and how much should be returned to investors. If it has had a bad year and it doesn’t have enough profit to cover its investment needs and the dividend, but expects the poor performance to be a one-off, then it may still make a payout to investors by either dipping into any surplus cash it has or using debt.
The dividend policy dictates how the value of the dividend is calculated and when it is paid. It also clarifies who gets what if a business has multiple share classes. For example, preference shares are usually entitled to dividends before common shareholders while American depositary receipts (ADRs) often earn a different dividend to other investors. Some share classes may not be entitled to dividends at all.
Some companies also choose to add what is known as a ‘scrip alternative’ dividend programme, which allows shareholders to receive the value of their dividends in new shares in the business rather than cash. Dividend policies may also include clauses that detail how bonus payments may work, such as special dividends or share buybacks.
Types of dividend policies
There is no definitive way of forming a dividend policy but there are four main types that are used by most publicly-listed businesses. However, there are additional ways to return cash to shareholders too.
Residual dividend policy
If a company has a residual dividend policy then it pays whatever cash is left in the business once all expenditure has been taken into account. This means that shareholders receive the sums left after the company has taken the likes of capital expenditure, investment and working capital into account.
This is regarded as the most sustainable and logical dividend policy to have as it means a business only pays out what it can afford each year. Although, it does mean that dividend payments can be volatile depending on the performance of the business and its spending requirements: if it suddenly needs to invest more money then there will be less left for shareholders, or if it underspends then investors will receive more. A residual dividend policy can be regarded as a form of zero-based budgeting for dividends, with the dividend being reviewed each year from a zero base and justified each year regardless of previous payouts.
A residual dividend policy provides greater flexibility to companies compared to other policies, as it puts growth needs and investment before distributions. However, it also means dividends will vary each year depending on how the business has performed.
Stable dividend policy
If a company has a stable dividend policy then it tries to make a consistent payout each year regardless of how the business has performed. Instead of basing the dividend on the company’s performance over the short term, stable dividend policies are more closely linked with long-term prospects and forecasts. Ultimately, the policy aims to grow dividends at roughly the same rate as long-term earnings. A common way for a stable policy to be structured is to use a target payout ratio, which outlines what share of its earnings will be returned to shareholders over the medium to long term.
The benefit of a stable dividend policy is that payouts are reliable and consistent, even if the business suffers short-term turmoil. A company will try to honour the dividend even if it has had a bad year, dipping into cash reserves if profits are not enough to cover it, providing something of a safety net for shareholders. However, it may change the policy or rebase the dividend if it believes its sub-par performance will continue for longer. This also means that shareholders won’t see a large rise in distributions when the company has a better than expected year either, with companies more likely to retain the cash.
A stable dividend policy comes with commitment. Investors expect dividends to remain consistent even if the business enters a downturn, although companies can hoard cash when things when are on the up as they are not obligated to return it to investors.
Progressive dividend policy
If a company commits to a progressive dividend policy then it is pledging to grow the dividend each year. Like stable dividends, the payout is linked to long-term earnings forecast for the business. The main difference is that, if earnings grow, then a progressive policy aims to raise the dividend by a similar amount, but if earnings fall the company will still raise the payout.
This is a popular policy for investors as it virtually guarantees higher dividends each year regardless of how the business performs. However, if a company has a progressive payout and is struggling then questions can be raised about how sustainable the policy is and the justification of spraying shareholders with cash if it doesn’t have the resources to. A company’s share price can find support if it demonstrates an ability to deliver a progressive payout over a longer period of time but it does severely limit a company’s flexibility if business deteriorates.
Regular dividend policy
A regular dividend policy, also known as a constant dividend policy, sees payouts closely linked to the company’s performance, both rising and falling in line with earnings. This often involves setting a payout rate. For example, a payout rate of 20% would mean shareholders will collectively receive 20% of the company’s earnings each year, whether that be 20% of a £10,000 profit or 20% of a £10 million profit.
The main characteristic of a regular dividend policy is that payouts move in line with earnings: if the company reports a 50% rise in profit then dividends should follow suit, but if they fall 50% then so will the dividend. This means investors reap the reward of a stellar year but also lose out if times have become tough.
This can lead to volatile dividends for investors, but it does mean payouts are more sustainable because they are directly linked to earnings, and as the business is committing to a fixed rate of earnings it has more certainty when planning future budgets.
Irregular dividend policies: special dividends
Some companies will pay dividends without adopting a formal dividend policy. Some businesses come into large amounts of cash that they want to return to shareholders without having to promise it will continue making payouts in the future. This can happen if a company sells a valuable asset and books a tidy profit. Similarly, if a business makes a large amount of profit one year but it doesn’t expect that to repeat going forward then it may pay a dividend without adopting a policy.
There are two primary ways of making a one-off distribution to shareholders. The first is what is known as a ‘special dividend’. These are one-off payments made to shareholders and often made in addition to ‘ordinary dividends’. This ensures that the one-off special payout doesn’t distort the ordinary dividend policy or raise expectations for the following year. If a special payout was combined with the ordinary one then there is a risk that shareholders will expect an even larger payout the following year, even if the driver of the special payout (such as an asset sale) doesn’t repeat.
Special dividends are a way of making a one-off return to shareholders, which gives businesses great flexibility. Companies do not usually have a policy for special dividends but some regularly pay them on top of ordinary dividends.
It is also worth mentioning scrip dividend programmes, which allow investors to receive new shares in the company rather than a cash payout. A business operating a scrip dividend will give investors the choice of receiving the cash dividend or new shares. The value of the cash dividend is usually higher than the scrip dividend price, but taking new shares is a cost-effective way of increasing your stake in the business and benefit further from future dividends or special payouts.
Scrip dividends, unless countered with a measure like a buyback, do dilute investors by releasing more equity. However, it allows businesses to make a return to shareholders without having to spend any cash. Scrip dividends can also have advantages.
How to find out what a company’s dividend policy is
The best place to find a company’s dividend policy is in its annual report. If a policy is in place then there will be a dedicated section that outlines the details. Information on share buyback programmes or scrip alternatives, if applicable, is likely to be included in their own sections nearby.
Larger businesses often have a dividend section on their investor relations website. This usually focuses more on when dividends that have already been declared will be paid.
Why is a company’s dividend policy important?
Dividends form a significant part of a company’s strategy and investment case. Paying dividends is treated as a sign that a business is financially healthy - although, don’t judge a company’s financial strength solely based on dividends. Dividends provide a steady return to potential investors. Without dividends, shareholders must rely on share price appreciation as the sole the only way of turning a profit.
The attractiveness of some companies highly depends on the dividend. Take utility companies as an example. Supplying electricity and gas is a highly regulated industry and, although stable, provides limited opportunity for growth. Revenue rarely experiences large movements year-on-year (YoY) and profits tend to be more stable. Although you could argue this means they have less potential than other stocks and are rather boring, they tend to be the most reliable dividend payers in the market. These types of stocks are referred to as income stocks.
Companies place a different priority on dividends. Some, such as investment companies, put shareholder returns at the top of the list while others only prioritise payouts once other needs are met, such as capex.
Dividend policies provide a clear path for investors to follow and tells the market what to expect. By adopting a policy, a company is committing to make some form of return to shareholders on a regular basis. Like any target, delivering dividends as promised suggests a business is meeting its goals, but if it fails to keep its promises then shareholders can be quick to turn on the business.
It is important to remember that companies are under no obligation to pay dividends to shareholders and that payouts can become vulnerable rather quickly. If a business is deteriorating and needs to tighten the purse strings then the dividend is a logical place to start to make savings. Equally, if business is booming then dividends are a logical way of returning excess cash to shareholders, which don’t like to see money sat idle in the bank and not being spent.
Investors know what to expect if a dividend policy is in place and can forecast where future payouts are headed depending on the company’s forecasts or prospects. A policy can also help businesses better plan their spending. However, if a company does not have a suitable policy in place then it can find itself unable to fulfil its promises, and shareholders do not take kindly to U-turns. Having said that, sticking to a policy when you can ill-afford it runs the risks of having to fund payouts using debt and delaying the problem.
How to analyse dividend stocks
Investors need to conduct a full analysis of a company to truly understand its dividend. Gauging the company’s prospects, cash flow and debt will help comprehend how fit it is to pay its dividend. A company may look attractive because it pays a decent, reliable dividend, but that is no good if it has high levels of debt, forecasts weaker growth or its cash flow is coming under strain. Ultimately, finding a stock that pays generous dividends is easy, but finding one that is safe over the long term is harder.
Importantly, a company’s dividend should be compared to peers in its own sector, as some industries are more renowned for payouts than others.
Below is a list of key metrics investors can use to analyse a company’s dividend:
Dividend payout ratio
The dividend payout ratio shows how much of the company’s earnings are being paid as dividends. This can be measured by dividing the dividend per share by the earnings per share (EPS) over the same time period. Technically, the higher the dividend payout ratio the better as this demonstrates a bigger proportion of earnings are being returned to shareholders. However, investors should be aware that a very high dividend payout ratio also suggests the company has little wiggle room if it hits hard times without cutting or abandoning payouts. Similarly, a low payout ratio suggests a company is not distributing as much of its earnings to investors as other companies, but it does suggest there is more upside to future dividends going forward.
The dividend yield is calculated by dividing a company’s annual dividend by its share price, demonstrating the ratio between the two. This is primarily used to analyse the stock purely from a dividend perspective. So long as the dividend remains unchanged, the yield will fluctuate in line with the share price. This does mean it can be distorted by volatility in share prices (if a dividend-paying stock suffers a large fall in share price one day, then the yield will look abnormally high, and vice versa). Ultimately, this analyses the performance of the dividend in relation to the share price.
Dividend cover helps investors understand how sustainable a company’s dividend payments are. This is calculated by dividing a stock’s EPS by the dividend per share, which will show how many times the company could cover its dividend payout. For example, if a company booked EPS of 10p and paid a dividend of 2p, it would have a dividend cover of 5x, meaning it could pay that dividend five times out of its pool of earnings.
Free cash flow to equity
Free cash flow is a key metric that underpins a company’s ability to pay dividends. The free cash flow to equity ratio measures how much could have been returned to shareholders. It is measured by taking the company’s profit, adding net debt and then subtracting the liabilities and obligations – including capital expenditure, debt repayments and working capital. This will reveal how affordable the dividend is for the business. Ultimately, this is a similar metric to dividend cover as it shows the company’s ability to pay its dividend – shareholders at least want to see that a business is generating enough cash to fund payouts.
Net debt to EBITDA
This is measured by dividing the company’s net debt (total liabilities minus cash and cash equivalents) by its earnings before interest, tax, depreciation and amortisation (EBITDA). This shows a company’s ability to manage to its debt pile with its own earnings, which is important because if a company can’t afford its debt then it is hardly in a position to pay a dividend. Similarly, if it is comfortably on top of its debt then it has a greater ability to make payouts to investors. The lower the ratio the better, but it also worth tracking this metric over the longer term as it can flag if a company’s balance sheet is strengthening or weakening.
Dividend dates: important events for your calendar
There are four key dates to watch out regarding dividends. These apply to UK-listed stocks:
The day that the dividend payment is announced. This is often unveiled at the same time as results are released (whether that be quarterly, interims or annual), but some companies release separate announcements that solely concern the dividend. This is effectively confirmation of what the latest dividend will be, and therefore these announcements often affect share prices as the market reacts to the better or worse than expected payout. The subsequent dates are usually outlined when the dividend is announced.
The record date is extremely important for investors. Investors that are on a company’s shareholder register as of the record date will be entitled to dividends. If you held shares in a business when it announced the dividend but sold them before the record date, then you would not be entitled to that dividend. This is the date that the company establishes who will receive its latest payout. Share prices can find support in the days leading up to the record date as demand tends to be stronger as investors aim to purchase shares in order to secure the dividend.
The ex-dividend date is the day after the record date. The dividend has not yet been paid, but anyone who purchases shares in the business after the record date will not qualify for the payout. Going ex-dividend has a severe impact on share prices as they tend to decline to account for the cash that is to be taken out of the business to pay dividends. A share with a dividend attached is obviously worth more than one without a payout. If you buy shares in a business on or after the ex-dividend date then you will only be entitled to future payouts – so long as you are on the register on the record date next time around.
The payment date is the day the dividend is paid to investors that were on the register on the record date. This is when the cash officially leaves the business and is returned to investors, but the impact on share prices is usually minimal as the effect of the dividend has often been priced in by this point.
Dividend policies: providing certainty but no guarantees
Dividend policies help provide some clarity about shareholder returns, but they should not be taken as gospel. Although many stocks try their upmost to deliver what they have promised it is not uncommon for companies to rebase their dividend or abandon it altogether if it has become unsustainable after several years of hardship. Some companies have no choice after plugging funding shortfalls with debt, which is no way to fund shareholder returns over the long term. For many, a less generous but more reliable dividend is the more responsible option.
Companies adopt various types of dividend policies, some of which are more suitable for certain industries than others. The type of policy it installs also says a lot about a company’s confidence and focus. Committing to a progressive payout is a bullish sign that earnings will grow over forthcoming years. Regular or residual policies are considered more prudent and sensible choices, while stable policies are geared toward long-term growth and provide upside to payouts while limiting the downside.
Investors have several ways to analyse the dividend of a company but must incorporate this into a broader evaluation of its business. Understanding a stock’s dividend using a variety of ratios is important as this can play a big part in evaluating how best to maximise potential returns on your investment, but understanding the safety and sustainability of the dividend is just as important.
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