Question

Dividend policy of a company may affect dividend signalling when?

Answer 1

Dividend Policy is the policy followed by a company with respect to dividend payouts in the long run. In the case of established companies, investors can have a fair idea of the dividend income they will earn, year after year, by following the dividend policy. Generally, there are three types of policies for dividend payouts-

(1) Stable Dividend Policy; In this case, the amount of dividend per share will be stable and constant over a period of time. While this policy enables the investor to anticipate his dividend income with a fair degree of certainty, this suffers from the lack of possibility of higher payouts in the years of better profits.

(2) Constant Dividend Policy: Companies following this type of Dividend Policy pay a definite percentage of their earnings every year. The amount of payout may vary according to amount of profit earned each year. While this policy allows higher dividend income for the stakeholders in the good times of the company (of course, with the probability of lower income in bad times), it suffers from the lack of certainty for the investors with respect to the current income, especially the long term investors.

(3) Residual Dividend Policy: Under this policy, dividend is paid only out of the surplus profit, after setting apart amount required for capital expenditure and working capital. While this policy denies the comfort of certainty of periodical income for the investors, some hail it as progressive for capital appreciation. Because, this policy puts the growth plans of the company ahead of individual investors' immediate income concerns. Such a strategy will be beneficial for the investors in the long run, as they can reap the benefits of companies growth after some time.

Dividend Signalling is the announcements or indications by the companies regarding possible payouts in a given time frame, more specifically, for the running year. This is based on the Management's perception of possible earnings during that period and its intention of the percentage of retention. As the higher dividend signal indicates possibility of higher profits which, in turn, will yield higher dividend income and capital gain, it normally cause immediate boost in the share price.

In the case of companies following the first type of Dividend Policy discussed above, ie., Stable Dividend Policy, Dividend Signalling is affected or is made insignificant. Because, under this policy, dividend payout is stable and predetermined, no matter whatever is the company's earnings. For companies following Constant Dividend Policy, dividend signalling will give indications of the earnings potential, as the amount of payout is proportional to the amount of profit, though the percentage is constant.For those following Residual Dividend Policy, Dividend signalling is of more significance to the stakeholders, especially the short term investors.