An important concept to know when it comes to the distribution of dividends is the dividend payout ratio. The dividend payout ratio indicates which percentage of each dollar earned is distributed in cash to the shareholders. It is calculated as follows:

Dividend payout ratio = cash dividend per share/earnings per share

Generally the higher the dividend payout ratios the more attractively are shares of the firm seen by investors. Dividend payout ratios vary significantly between industries and organizations. The liquidity position of the company is one of the factors that affect the dividend payout ratio the company selects.

Test yourself:

ABC Company issued cash dividends of $3 per share. ABC’s earnings per share are $8. What is the dividend payout ratio?

Solution:

Dividend payout ratio of ABC = 3/8= 37.5%

This indicates that out of each dollar of earnings, 37.5% is distributed to shareholders as cash dividends.

Constant payout ratio dividend policy – according to this dividend policy, stockholders receive dividends at a fixed percentage rate from earnings every financial period that resulted in a profit. In financial periods when loss is incurred, no dividends are distributed. Dividends increase or decrease based on the amount of profit the firm made during a particular year. This type of dividend policy is not recommended because fluctuations in the dividends from one period to another may adversely affect the share price.

Constant dollar (stable) dividend policy – according to this dividend policy, a fixed amount of dollars per share are paid each period which resulted in a profit. The amount of fixed dollar dividend only increases after an increase in earnings proves to be stable.

Regular with extras dividend policy – according to this dividend policy, fixed amount of dollars per share is paid every period. On years when the profit exceeds normal, extra dividend is paid.

Residual dividend policy – This dividend policy is aligned with the residual theory of dividends. The residual from retained earnings is paid after all acceptable investments were undertaken.

Target dividend payout ratio

It is advisable for firms to establish target dividend payout ratio and then use it for guidance in determining dividend levels. Target dividend payout ratio refers to a specific percentage of earnings that firms would like to pay in dividends.

For example, if the target dividend payout ratio is 40% then the firm intends to try to keep its dividends around 40% of its earnings. The target dividend payout ratio is very useful in cases of constant dollar dividend policy and regular with extras dividend policy. Under these policies a regular dividend is paid each period. However, organizations can use the target dividend payout ratio as a guide to decide when dividends can be adjusted to reflect a stable new level of earnings.

Shareholders usually prefer regular and regular with extras dividend policies because it involves a smaller degree of uncertainty regarding the dividends to be received in each period.

Cash dividends and stock dividends

Cash dividends are dividends which are paid out in cash to the shareholders via cheque or electronic transfer. When cash dividends are distributed to shareholders, the share price tends to drop by an amount similar to the cash dividend. This occurs because the economic value was distributed from the firm to shareholders. Shareholders have to pay tax on cash dividends. Therefore, the amount that they receive decreases in value.

Stock dividends are dividends paid out in additional stock. There is no cash outflow. The funds are just shifted between accounts (from retained earnings to common stock and paid-in capital in excess of par).

If a company issues a 3% stock dividend this means that if one owns 100 shares of this company than 3 additional shares will be received. Overall, stock dividends do not bring any value to the shareholder. Stock dividends decrease the share price.

To determine by how much share price will decrease, let’s look at an example. Assume that shares of ABC sold for $17 each. ABC decided to distribute a 10% stock dividend. The share price will decrease as follows: $17 * (1/1.1)=$15.45.

If individual Y owned 1,000 shares before the stock distribution, after stock distribution individual Y will own 1,100 shares. The market value of shares of individual Y remains unchanged as shown below:

1,000 * $17     = $17,000

1,100 * $15.45 = $16,995

Therefore, as can be seen from the above, the shareholders’ market value of shares remains unchanged.

If the most recent earnings of ABC were $350,000 and individual Y owned 1% of the firm’s shares than earnings per share before stock dividends were $3.5 ($350,000/$100,000). If earnings are expected to stay the same than after the stock dividends, then earnings per share would decrease to $3.18 ($350,000/$110,000). Individual Y’s share in earnings stays the same. It was $3,500 (3.5*1000) and now it is $3498 (3.18*1,100).

Shareholders do not really obtain real value due to such stock dividends. It is more a perceived value of obtaining more stock. Consequently, shareholders generally do not have to pay tax on stock dividends unless the cash dividend option is present. For organizations, stock dividends are more costly but can be appropriate if the organization needs cash to finance a rapid growth.

Test yourself:

ABC shares are currently sold for $20 each. ABC decided to distribute 5% stock dividend. By how much the share price will decrease?

Solution:

The share price will decrease as follows: $20 * (1/1.05)=$19.05.

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