Constant Dividend Payout Ratio Policy

What Is A Constant Dividend Payout Ratio Policy?

A constant dividend payout ratio policy is when companies distribute a fixed proportion or a fixed percentage of their net income to shareholders in the form of dividends in a given cycle.

In other words, under this policy, shareholders are expected to be paid a consistent percentage of net income in the form of dividends regardless of whether the company generated a substantial net profit or earned slightly higher than the break-even point. 

We are usually provided with the constant dividend payout ratio, but in some cases, we have to calculate the ratio by rearranging the components of the payout ratio. As a result, the ratio is calculated as follows:

Dividend Payout Ratio = Total Dividends/ Net Income

where,

• Dividends Paid: The amount of dividends in dollars paid to shareholders in a given period
• Net income: It is the income after deducting COGS (Cost of Goods Sold), expenses, and taxes

However, if, in some cases, the dividends paid and net income are unknown, the retention ratio can be used to calculate the dividend payout ratio as follows:

Dividend Payout Ratio = 1 - Retention Ratio

where,

• The retention ratio is calculated as the retained earnings divided by the net income. Retained earnings represent the portion of net income that is kept by the company for reinvestment and is not distributed as dividends.

Or, we can use another formula to calculate the Dividend Payout Ratio:

Dividend Payout Ratio = Dividends per Share / Earnings per Share

Example of a Constant Dividend Payout Ratio Policy

Let us assume that after reviewing the financial metrics of ABC Incorporation for the past 12 months, its board of directors gathered in the headquarters to vote on the constant dividend payout policy for ABC Inc. 

After lengthy meetings, the board has finally voted on a constant payout ratio policy to distribute 25% of net earnings to shareholders from 2022 to 2024. However, the board also emphasized revisiting in mid-2023 to hold discussions on whether the policy should be continued beyond 2024.

Following this announcement, the company's Budgeting, Planning, and Forecasting (BP&F) forecasted the net earnings to be $300, $321, and $314, respectively, from 2022 to 2024. 

Even though the process of forecasting earnings involves complex science and artwork, for simplicity, we only excerpt the projected annual earnings. Company ABC's outstanding common stock will be 145 for the next three years.

In MM, except per share data

We thus calculated that with a constant dividend payout ratio of 25%, company ABC dividends per share are $0.52, $0.55, and $0.54 for the years 2022 to 2024, respectively. 

We can see that even though the ratio is held constant, 25%, throughout the years 2022 to 2024, the expected dividends per share dollar amounts fluctuate owing to the volatility in total annual earnings.

Major Considerations for Setting the Constant Dividend Payout Ratio Policy

There are many factors the board of directors considers when formulating the policy. 

Since the board is the pyramid of the organizational hierarchy, it must collaborate cross-functionally with all departments to ensure that defining new policies is pertinent to the business's strategic objectives.

The board's secretary is responsible for maintaining accurate records of board meetings and activities; they do not typically act as a liaison between the board and the management. The executive team or the board chair usually manages communication with the management.

The board chair ensures that information presented to the board is timely and accurate, focusing on relevant financial details. Their role is to oversee the overall functioning of the board and facilitate effective decision-making.

For the board to make informed decisions, they have to follow set rules in evaluating trends based on historical data while also considering expected figures about the financial performance of the corp.

While there are numerous cyclical, non-cyclical, quantitative, and qualitative factors involved in the board's planning, the major factors influencing the payout ratio policy are as follows:

Current Life Cycle of the Business

Companies in their initial stages of life cycle require an excessive amount of cash for expansion. Therefore, the board of directors opts not to pay dividends at all or set a lower payout ratio relative to more mature firms that have reached their growth peak.

One might wonder how the retained earnings are allocated to shareholders on the balance sheet, and the answer is: 

"that most companies offer a plan called Dividend Reinvestment Plan (DRIP) in which shareholders at their discretion can buy additional shares using only their dividend dollars."

Shareholders participating in a Dividend Reinvestment Plan (DRIP) can use their dividends to purchase additional shares, but they may need to contribute additional cash if the dividend amount is not sufficient to buy whole shares.

They can also lower their average cost-per-share as shares issued for dividend reinvestment are sometimes offered at a lower price than the closing price on the relevant date.

Reinvestment in the same company/industry may not provide as much diversification, whereas it protects against equity dilution. Hence, shareholders or brokers must conduct their cost-benefit analysis for optimal solutions.

For example, Apple (AAPL) did not pay any dividends from 1996 to 2012. The lower dividend payout ratio policy remained in place until the company reached maturity when the firm could not expand further.  

Cost Efficiency 

Most immature companies do not have a published bond rating and struggle to raise capital through debt financing. This means that creditors hold a bearish sentiment about the growing company's ability to meet interest obligations or even reach the survival stage.  

Additionally, growing firms do not have a harmonious relationship with syndicates and, therefore, will accrue high commission fees when hiring these syndicate members to help them secure external capital through an Additional Public Offering (APO) or syndicated loans.

Another reason to favor dividend reinvestment over debt financing is to minimize the fixed costs of the operation. 

Companies that borrow money are obliged to pay interest every fiscal year. An increased debt results in huge interest liability for a given period, skyrocketing the fixed cost. 

Ergo, it is reasonable that these small firms use internal financing as reinvestment of dividends will not only avoid paying hefty commission fees to investment banks but will also prevent the company from entering into contractual interest payment obligations should they raise debt. 

This is not to say that only newly launched firms pay lower dividends. On the contrary, fully-grown companies with lower bond ratings also bear a higher cost of debt and thus decide to retain the earnings not necessarily for expansion but to maintain liquidity. 

Shareholders Dividends Expectations

Shareholders invest in equity to either receive an income stream through dividends or earn capital gains from stock appreciation. 

This two-tailed road leads to different expectations amongst stockholders, where some prefer to receive dividends periodically while others can hold on for long-term capital gains.

We must examine each group's motives to grasp the art behind different dividend expectations. First, some investors who choose to buy dividend-paying stocks are retail investors aiming to use the stream of dividends to fund their cost of living.

A small portion of the customer base for dividend-paying stocks are investors who buy stocks that do not pay dividends. 

It is normal to be confused about it, but let us say more. Shareowners who invest in high-growth industries like technology and biomedicine might receive lower dividends, as these companies often reinvest more profits into the business.

So, these investors bear in mind that the success of a tech stock depends on whether the R&D can successfully develop an innovative technology that will soar up the stock price. If otherwise, the portfolio entirely packed with tech stocks will be wiped out. 

To risk-adjust for this potential loss, allocating dividend-paying stocks to their portfolio is an excellent way of diversification, as the dividends received from these stocks will already have generated a realized return that can be used to offset any potential losses from non-dividend-paying stocks.

We have examined that there is a dispersion in dividend expectations from shareholders. To better accommodate that, the board of directors decides on optimal payout policies that would respond to a wide range of expectations and thus attract bulls and bears.

Advantages of constant dividend payout ratio policy

While a company could implement numerous dividend policies, there are significant advantages to having a constant dividend payout ratio. 

1. Predictability for Shareholders

Under a constant dividend payout ratio policy, a fixed percentage of earnings is distributed to shareholders. As shown in the illustration section, shareholders will receive dividends directly proportional to the firm's net earnings.  

This policy provides more flexibility as the company's cash outflow to investors is conditioned by cash inflow from operations. In other words, the company's cash will only be eroded if operational activities generate more cash. 

2. Flexibility for the Company

A known dividend percentage of future fiscal years provides management with flexibility in Financial Planning and Analysis (FP&A) as they are not forced to deal with uncertainty, which may require them to alter other uses of cash to have sufficient cash in hand to meet dividends obligations.

For example, when a company plans to spend $10M on CapEx three years from now, it will be sure of how much of its earnings will be available for capital expenditures. 

3. Financial Planning Ease

If not for the constant dividend payout ratio policy, the firm will have to set aside a fixed dollar amount of future earnings for dividends. With fluctuations expected in earnings, even a very sophisticated model will fail to forecast accurately. 

Disadvantages of constant dividend payout ratio policy

While having a constant dividend payout to investors can have its benefits, there will also be drawbacks:

1. Income Volatility

Given that under the constant payout policy, the dividends paid are tied to net earnings, fluctuations in net earnings create volatility for investors' dividend income. If a company experiences fluctuations in its earnings and, also in its dividends, it can erode investor confidence.

Unpredictable dividend payments might cause shareholders to question the company's ability to sustain financial performance, leading to decreased investor trust and potentially resulting in the outflow of investments.

2. Uncertainty for Shareholders

The pitfall of volatility in constant dividend payout policy leads to uncertainty in shareholders' financial planning. This can impact the long-term value of a company's shares.

When dividend payments become unpredictable due to fluctuations in earnings, investors might seek alternative investment opportunities that offer more stable income streams.

Conclusion

A company with a constant dividend payout ratio policy pays shareholders a fixed percentage of net income as dividends. 

The constant payout ratio is calculated as dividends paid out divided by net income for a given fiscal year. The board sets the payout policy, which must consider numerous factors.

A company in its growth stage will follow a no-dividend or small payout ratio and offer Dividend Reinvestment Plans (DRIPs) to investors. At the same time, a more established company will periodically pass the earnings to shareholders.  

Another factor that impacts the policy is a firm's ability to raise cash from external sources. A newbie will use internally generated cash to fund its expansion as external funding is limited due to the bearish sentiments of lenders about the startup.

We also discussed the shareholders' expectations as a driver for the dividends policy. We illustrated that different investment strategies require a stock to pay constant dividends, whether for funding the cost of living or simply using it as a risk diversifier. 

Lastly, we demonstrated the merits and demerits of a constant payout ratio policy that provides the management with certainty and flexibility in financial planning.

Researched and authored by Abdul Aziz Rasheedy | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Dividend Coverage Ratio
• Dividend Growth Rate
• Dividend Reinvestment Plan (DRIP)
• Stock Dividend
• Sustainable Growth Rate