Question

Compare and contrast the following dividend policies: the constant payout ratio policy and the constant dollar payout policy. Which policy do most public companies actually follow? Why?

Answer 1

Constant payout ratio policy :

A constant dividend payout ratio policy is a dividend policy in which the percentage of earnings paid in the form of dividends is held constant. In other words, a constant dividend payout ratio policy maintains the same proportion of earnings paid out as dividends to shareholders.

With a constant dividend payout ratio policy, the amount of dividends paid to shareholders fluctuates directly in proportion to the earnings of a company. Therefore, such a dividend policy comes with the potential to generate very volatile dividend payouts.

The dividend payout policy also offers companies more flexibility as they do not need to alter the payout(s) during deteriorating market conditions (since the payout is a proportion of earnings and not a dollar amount), which typically sends a negative signal to market participants.

Constant dollar payout policy :

If a company is following the policy of paying constant dollar amount, the amount of dividends paid every year will be the same irrespective of the earnings. Under this policy, the company knows exactly what amount of cash will be required on payment date and can arrange for cash to be available at that time. From the investor’s point of view, this policy allows them to know exactly what amount of dividend they would receive and hence there is no uncertainty.

However, there are problems if a company follows this policy. If the earnings are less than the amount of dividends, it has to resort to using the retained earnings to pay the dividends which would decrease the amount of shareholder equity. If in any year, it has large amount of earnings and only a fixed amount is paid out as dividends, it is necessary for the company to retain a large amount of earnings. If the company does not have sufficient investment opportunities, retention of large amount of earnings will not be a good policy. This policy is appropriate for a company which has reached a stable stage and its earnings are not very volatile so that they will have just sufficient earnings to pay the dividends.

Public companies follow constant payout ratio beacuse

1. Current business life cycle :

Companies that operate in the launch, growth, and shake-out stage of the business life cycle tend to offer a lower payout ratio compared to more mature and established firms. In the early stages of a company, it will tend to choose to follow a low payout ratio policy so that it can reinvest its earnings back into the business.

2. Industry outlook :

Setting a constant dividend payout ratio requires forward thinking – pullbacks to a company’s dividend policy result in an adverse effect and signals a weakening company. A company must consider its future prospects and its earning potential before setting a constant dividend rate.