How the Dividend Policy of a Company Affects You As an Investor

The average investor will tell you that he or she invests for one reason and one reason only: to make a profit. No investor ever invests their money with the goal of making a loss. In fact, profitable earnings (also known as dividends) are usually one of the biggest factors that influence an investor’s decision. 

In this article, we shall take a closer look at how the dividend policy of a company affects you as an investor. Upon reading this article, readers will be able to identify the types of profits companies give to their investors, the reasons for dividend payouts, how a company determines its optimum payout ratio in the dividend policy as well as how the dividend policy affects your investment decision.

First, let us take a look at basic investment profits. In stock market investing, there are two basic types of profits that we can reap:

Why do companies pay dividends?

When a company makes a profit, they must decide on what to do with the profits. They can choose to retain the earnings for capital expenditure, research and development or other investment opportunities for expansion purposes. This is usually the case for companies that are still expanding or experiencing growth. However, for companies that are already at the steady stage of business, they will usually choose to distribute most of the profits as dividends to shareholders.

What is a dividend policy?

A dividend policy is how a company determines the amount of earnings to be paid out as dividends to its shareholders on a regular basis. It is characterized by its dividend payout ratio, which is the percentage of net earnings paid out to shareholders. Before a dividend policy is established, there are a few factors that the management will consider in order to determine the optimum payout ratio.

Factors that will influence the optimum payout ratio

(i)           Basic expectations: Some investors prefer current dividends, which are less risky than future gains while others are willing to take the risk of future capital gains with the expectation of higher rate of return in the future. 

(ii)         Investment opportunities: If the company is at the growth stage with good investment opportunities, the management may want to retain earnings to fund its investments. 

(iii)       Target capital structure:  Most companies have targeted capital structure, which is the ratio of debt versus equity financing. If the company is already high in debt, the management may decide to retain earnings to adjust the ratio back to its optimum level. 

(iv)        Availability and cost of external capital: If the cost of external financing is higher than internal funding, this will also affect the cash available for dividend payouts.

Based on the above factors, we can establish that a company’s dividend policy cannot be made separately from its financing and investment decisions. As an example, if a company decides to use internal funds to finance its investments, it will reduce the cash available dividend payouts. Other companies may decide to pay low dividends or retain earnings for reinvestment purposes.

The Dividend Policy and How it Affects Investors 

A stable dividend policy will always serve the best interests of a company and its shareholders. However, since the profits and cash flow of companies may change over a period of time, the tendency for companies to adjust dividend payouts in accordance with the cash flow is quite common. 

The danger of changing dividend policies is that it may send the wrong signals to investors, especially if the majority of them are looking for stable dividend payouts. From the management’s point of view, they may decide that the money is best   re-invested for research and development or capital investment, but investors may think that the company is struggling and therefore reducing its payout. On the other hand, if a company is too eager to return profits to shareholders, it may also indicate that the management has run out of new and innovative ideas to fuel the growth of the company. Any wrong signal sent out by unusual dividend policies may cause investors to become nervous, which could then lead to a sharp drop or increase in its stock prices.

Conclusion 

Investors interested in stocks that generate consistently high dividend income should place greater scrutiny on the companies’ dividend payment history. Only stocks with a continuous record of steady dividend payout over the past ten years or longer should be considered. Alternatively, take the time to study and truly understand a prospective company’s business model as it contains information that will help convince you if the company will be able or unable to generate the necessary cash flow for its dividend payouts.

© Securities Industry Development Corporation 2010. For more information on wise investing, log on to Malaysian Investor (www.min.com.my).

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*Note: This article was written by Mr Ooi Kok Hwa, holder of the Capital Markets Services Representative’s License to carry on the business of investment advice under the Capital Markets and Services Act 2007. The information provided in this article is only for educational purposes and reflects the market conditions at a specified point in time, which may lapse and affect the relevance of this article. This article does not necessarily represent the official view of Securities Industry Development Corporation and should not be used as a substitute for legal or other professional advice.