When speaking to business owners in management interviews, I always ask a couple of question:
What has been your dividend policy in the past? And, what do you expect it to be going forward?
Interestingly, many business owners reply that they don’t have a dividend policy. At that point, I reply that they have had a dividend policy historically, and that they will have a dividend policy prospectively.
What is a Dividend? And What is the Dividend Payout Ratio?
The net income of a business can be retained in the form of working capital, capital investment, or asset accumulation. For simplicity, assume no debt, because net earnings can also be used to pay down debt. We will talk about all the possibilities for the use of net income later. Earnings that are not retained are paid to owners in the form of dividends.
So, a dividend is that portion of the net income (after taxes) of a business that is paid to its owners during a particular period.
We calculate a dividend payout ratio by dividing the dollar dividend (or the expected dollar dividend) by dollars of net income. For example, if net income is $100 thousand for a period and the expected dividend is $40 thousand, the dividend payout ratio is 40% ($40 / $100).
If there is no dividend, the dividend payout ratio is 0%, but 0% is still a dividend payout ratio.
That’s why I say that every company has a dividend policy. The decision not to pay out dividends is just as much a policy as the decision to pay out 40% of earnings in dividends.
Types of Dividends
In this short post, we will identify a number of kinds of dividends (or dividend policies) that companies may have and comment briefly about them.
- Never pay a dividend. Some companies have never paid a dividend and never expect to pay one. Whether that is a good dividend policy is a subject for analysis and discussion.
- One time dividend. Some companies never pay dividends, but they have made one, or an occasional, exception. Maybe the dividend was paid to appease a shareholder, or to finance a personal purchase.
- Special dividend. A special dividend is a one-time dividend that is paid to the owners of a business. Quite often, the dividend is paid to reduce or eliminate excess cash. I think it is a good idea to get excess assets and extraneous, non-operating assets off of a company’s balance sheet, as I wrote here, here, and here.
- Constant dollar dividend. I have seen companies that decided years ago to pay a regular dividend, but the amount has never changed. If earnings are rising, this means that the dividend payout ratio declines over time.
- Set a dividend payout ratio target. A company might set a target of paying out 40% of its earnings to shareholders each year. If earnings decline, the dividend declines. And if earnings rise, the dividend rises.
- Dividend yield target. The dividend yield is the dollar dividend divided by the value of a company. If value is $100 per share and the dividend is $1.50 per share, the dividend yield is 1.5% ($1.50 / $100). The first time I consulted with a company to help set its dividend policy, this is the kind of policy that was established by the board. The policy was to pay a dividend to shareholders in each year equal to 1.5% of the value determined by the annual appraisal Mercer Capital prepared at the end of each fiscal year.
- Residual dividend policy. Some companies have an effective policy of paying out as a dividend any remainder of earnings after all working capital, debt-service requirements, and capital expenditures have been met.
- Leveraged dividend recapitalization. A leveraged dividend recap is a one-time event. A company borrows funds from a lending institution and pays out a one-time dividend to its owners. They all receive their pro rate share of the dividend and pay their taxes. They still own their same proportionate shares of the business after the one-time dividend. The company then, over time, repays the debt. Owners achieve near-term liquidity and retain ownership.
We could probably parse this thing called dividends some more, but you get the picture. There are enough examples here to get you thinking about your dividend policy, whether it is articulated or not.
Chapter 8 of my book Unlocking Private Company Wealth is titled “An Introduction to Dividends and Dividend Policy for Private Companies.” This chapter is a good place to start if you want to begin to think about your company’s dividend policy. If you are an adviser, it is a good place to become familiar with the concept of dividend policy and to enhance your ability to communicate with business owners.
As the title states: “Every company has a dividend policy. It is just a matter of articulating what it has been and what it is expected to be.”
I hope this short discussion of the types of dividends (and dividend policies) has been helpful. We’ll talk about dividends more in future posts.
In the meantime, be well!
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