Stockholders of dividend-paying shares benefit through steady income flows, portfolio growth through reinvestment, and favorable tax treatment. These shares provide regular payments to investors, which represent a portion of company earnings. What many investors do not take time to understand is how the dividend payment is determined.
First, it is important to understand why companies pay out dividends. These payments provide investors with a certainty regarding the financial well-being of the company. This may make an individual more inclined to invest in this stock versus one that does not pay dividends. Once a company begins paying dividends, it is important that it properly manage its dividend distribution process.
Companies generally employ a residual dividend policy, stability policy, or a combination. Under the residual policy, the company relies on equity that is internally generated to finance its new projects. Dividend payments result from any leftover or residual equity after the requirements for project capital are met. Attempts are made to balance the debt/equity ratios, so dividends will only be paid if money remains after meeting operating and growth expenses.
The residual policy can result in fluctuating dividends, while the stability policy provides more certainty. Companies may opt for a cyclical policy that establishes dividends as a predetermined fraction of quarterly earnings. Alternatively, they may opt for quarterly dividends established as a fraction of annual earnings. Either way, a stability policy aims to reduce uncertainty from an investor perspective, providing shareholders with income.
A hybrid of the stable and residual dividend policy can also be used. Companies look at the debt/equity ratio as their long-term goal. The company establishes a dividend that is a small portion of its annual income and can easily be maintained. An extra dividend will be paid when income exceeds targeted levels, allowing investors to share in the good performance of the company.
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