What is Stability of Dividends?
The stability of dividends is considered a desirable policy by the management of most companies in practice. Shareholders also seem generally to favor this policy and value stable dividends higher than the fluctuating ones. All other things being the same, the stable dividend policy may have a positive impact on the market price of the share.
Stability of dividends also means regularity in paying some dividends annually, even though the amount of dividend may fluctuate over years, and may not be related to earnings. There are a number of companies, which have records of paying dividends for a long, unbroken period. More precisely, the stability of dividends refers to the amounts paid out regularly.
Table of Contents
- 1 What is Stability of Dividends?
- 2 Forms of Stability of Dividends
- 3 Advantages of Stability of Dividends
Forms of Stability of Dividends
Three forms stability of dividends may be distinguished:
- Constant Dividend Per Share or Dividend Rate
- Constant Payout
- Constant Dividend Per Share Plus Extra Dividend
In India, companies announce dividends as a percent of the paid-up capital per share. This can be converted into a dividend per share. A number of companies follow the policy of paying a fixed amount per share or a fixed rate on paid-up capital as a dividend every year, irrespective of the fluctuations in the earnings.
This policy does not imply that the dividend per share or dividend rate will never be increased. When the company reaches new levels of earnings and expects to maintain them, the annual dividend per share or dividend rate may be increased. The earnings per share and the dividend per share relationship under this policy is shown in Figure.
It is easy to follow this policy when earnings are stable. However, if the earnings pattern of a company shows wide fluctuations, it is difficult to maintain such a policy. With earnings fluctuating from year to year, it is essential for a company, which wants to follow this policy to build up surpluses in years of higher than average earnings to maintain dividends in years of below average earnings.
In practice, when a company retains earnings in good years for this purpose, it earmarks this surplus as dividend equalisation reserve. These funds are invested in current assets like tradable (marketable) securities, so that they may easily be converted into cash at the time of paying dividends in bad years.
A constant dividend per share policy puts ordinary shareholders at per with preference shareholders irrespective of the firm’s investment opportunities or the preferences of shareholders. Those investors who have dividends as the only source of their income may prefer the constant dividend policy. They do not accord much importance to the changes in share prices. In the long run, this may help to stabilise the market price of the share.
The ratio of dividend to earnings is known as the payout ratio. Some companies may follow a policy of constant payout ratio, i.e., paying a fixed percentage of net earnings every year. With this policy, the amount of dividend will fluctuate in direct proportion to earnings. If a company adopts a 40 percent payout ratio, then 40 percent of every rupee of net earnings will be paid out.
For example, if the company earns ₹2 per share, the dividend per share will be Re 0.80 and if it earns ₹1.50 per share the dividend per share will be Re 0.60. The relation between the earnings per share and the dividend per share under this policy is exhibited in Figure 2.
This policy is related to a company’s ability to pay dividends. If the company incurs losses, no dividends shall be paid regardless of the desires of shareholders. Internal financing with retained earnings is automatic when this policy is followed.
At any given payout ratio, the amount of dividends and the additions to retained earnings increase with increasing earnings and decrease with decreasing earnings. This policy does not put any pressure on a company’s liquidity since dividends are distributed only when the company has profits.
For companies with fluctuating earnings, the policy to pay a minimum dividend per share with a step-up feature is desirable. The small amount of dividend per share is fixed to reduce the possibility of ever missing a dividend payment.
By paying extra dividends (a number of companies in India pay an interim dividend followed by a regular, final dividend) in periods of prosperity, an attempt is made to prevent investors from expecting that the dividend represents an increase in the established dividend amount.
This type of policy enables a company to pay the constant amount of dividends regularly without default and allows a great deal of flexibility for supplementing the income of shareholders only when the company’s earnings are higher than the usual, without committing itself to make larger payments as a part of the future fixed dividend. Certain shareholders like this policy because of the certain cash flow in the form of regular dividends and the option of earning extra dividend occasionally.
We have discussed three forms of stability of dividends. Generally, when we refer to a stable dividend policy, we refer to the first form of paying constant dividend per share. A firm pursuing a policy of stable dividend, as shown in Figure 10.1, may command a higher price for its shares than a firm, which varies dividend amount with cyclical fluctuations in the earnings as depicted in Figure 2.
Advantages of Stability of Dividends
The advantages of stability of dividends are mentioned below:
- Resolution of Investors Uncertainty
- Investors Desire for Current Income
- Institutional Investors Requirements
- Raising Additional Finances
Resolution of Investors Uncertainty
Usually, we argued that dividends have informational value, and resolve uncertainty in the minds of investors. When a company follows a policy of stable dividends, it will not change the amount of dividends if there are temporary changes in its earnings.
Thus, when the earnings of a company fall and it continues to pay the same amount of dividend as in the past, it conveys to investors that the future of the company is brighter than suggested by the drop in earnings.
Similarly, the amount of dividends is increased with increased earnings level only when it is possible to maintain it in the future. On the other hand, if a company follows a policy of changing dividends with cyclical changes in the earnings, shareholders would not be certain about the amount of dividends.
Investors Desire for Current Income
There are many investors, such as old and retired persons, women, etc., who desire to receive regular periodic income. They invest their savings in the shares with a view to use dividends as a source of income to meet their living expenses.
Dividends are like wages and salaries for them. These investors will prefer a company with stable dividends to the one with fluctuating dividends.
Institutional Investors Requirements
Financial, educational and social institutions, and unit trust also invest funds in shares of companies. In India, financial institutions such as IFCI, IDBI, LIC, and UTI are some of the largest investors in corporate securities. Every company is interested to have these financial institutions in the list of their investors.
These institutions may generally invest in the shares of those companies, which have a record of paying regular dividends. These institutional investors may not prefer a company, which has a history of adopting an erratic dividend policy. Thus, to cater the requirement of institutional investors, a company prefers to follow a stable dividend policy.
Raising Additional Finances
A stable dividend policy is also advantageous to the company in its efforts to raise external finances. A stable and regular dividend policy tends to make the share of a company a quality investment rather than speculation.
Investors purchasing these shares intend to hold them for long periods of time. The loyalty and goodwill of shareholders towards a company increase with stable dividend policy. They would be more receptive to an offer by the company for further issues of shares.
A stable dividend policy also helps the sale of debentures and preference shares. The fact that the company has been paying dividend regularly in the past is a sufficient assurance to the purchasers of these securities that no default will be made by the company in paying their interest or preference dividend and returning the principal sum.
Financial institutions are the largest purchasers of these securities. They purchase debentures and preference shares of those companies, which have a history of paying stable dividends.