Dividend Policy

Deals with how management wishes to deal with the business's unappropriated surplus.

Author: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Reviewed By: Himanshu Singh
Himanshu Singh
Himanshu Singh
Investment Banking | Private Equity

Prior to joining UBS as an Investment Banker, Himanshu worked as an Investment Associate for Exin Capital Partners Limited, participating in all aspects of the investment process, including identifying new investment opportunities, detailed due diligence, financial modeling & LBO valuation and presenting investment recommendations internally.

Himanshu holds an MBA in Finance from the Indian Institute of Management and a Bachelor of Engineering from Netaji Subhas Institute of Technology.

Last Updated:November 4, 2023

What is a Dividend Policy?

A company's dividend policy deals with how management wishes to deal with the business's unappropriated surplus. The administration formulates dividend policy in light of various internal and external factors.

When investors purchase a firm's shares, they expect the company to reward them in one of two ways.

  1. The business sets aside a portion of its earnings after interest and tax to pay shareholders. Such payments are called dividends. This allows shareholders to participate in the profits of the enterprise.
  2. The company does not pay dividends to its shareholders. Instead, it reinvests earnings into projects that would help grow the business. This, in effect, causes equity to appreciate. 

It is believed that if investments into projects yield a positive net present value, and the return on these investments is higher than what the shareholders could make with another comparable company, share price increases.

In other words, such growth positively impacts share prices, and shareholders benefit from capital appreciation.

How does a company pay dividends?

The most common form of Dividend is, of course, a direct cash payment. The company appropriates some of its profits to its shareholders.

The Dividend received would depend on the stake held in the business. For example, someone with a 10% interest in a company that set aside $1 million of profits for its shareholders would receive dividends of $100,000.

Here is an interesting tidbit of information for you. Finally, we can note an interesting fact about investor behavior.

If the company wishes to finance new projects, it can either issue new shares or retain its earnings.

However, issuing new shares deprives its existing shareholders of the benefit they would receive if the venture is successful.

In the above example, the shareholder holding a 10% stake could find that his stake has been reduced to 8% after a new issue of shares. Therefore, he would only receive 8% of the profits from the venture.

This theory, in short, is known as the signaling theory. Inversely, if the company were on the verge of making losses, it should opt for a share issue to spread the losses among existing shareholders.

Aside from cash dividends, the company rewards its shareholders through bonus shares, stock splits, and buybacks.

Bonus shares and stock splits

By opting for bonus shares and stock splits, the business rewards its shareholders by increasing the number of shares they hold. The investors' overall holding in the company will not change.

In a bonus issue, the company issues additional shares to each shareholder (at no cost) in a specific ratio. For example, the board may declare that each shareholder will receive one additional share for every two he holds.

Therefore, a shareholder holding 300 shares will now have 150 additional shares, meaning that his portfolio will now contain 450 shares.

A stock split has the same effect as a bonus issue, though it is different in its accounting treatment.

In a stock split, the overall paid-up capital will remain the same while the number of shares held by each shareholder increases.

MonkeyArmy Ltd. has 30,000 shares, each worth $100, bringing its paid-up capital to $3,000,000. In addition, it conducts a stock split wherein each shareholder receives ten shares for every share.

After the stock split, MonkeyArmy Ltd will have 300,000 shares worth $10 each. The total paid-up capital still stands at $3,000,000.

In a bonus issue, the paid-up capital of the business increases. Since the shareholders do not pay for the bonus shares, the business would meet the proceeds from its reserves.

Continuing with the above example, let us assume that MonkeyArmy Ltd. shares carry a premium amounting to 20% of the face value of the claims. In addition, the enterprise has retained earnings amounting to $5,000,000.

In the example given below, we can see that, due to a bonus issue, the paid-up capital has gone up by $1.5 million, and the share premium has increased by $300,000.

The company would have to meet the proceeds of $1.8 million out of its reserves of $5 million, bringing the retained earnings down to $3.2 million.

Observe that the shareholders' funds do not change, irrespective of whether the company opts for a bonus issue or a stock split.

  No change Bonus issue (1 share for every 2 held) 1:10 Stock split
Number of shares 30,000 45,000 300,000
Price per share 100 100 10
Paid up capital 3,000,000 4,500,000 3,000,000
Share premium (20% of face value) 600,000 900,000 600,000
Reserves and surplus 5,000,000 3,200,000 5,000,000
Total shareholders’ funds 8,600,000 8,600,000 8,600,000

Share buyback vs. Dividends

The company repurchases some of its outstanding shares from the open market in a share buyback scheme. Because of this repurchase, the total number of shares outstanding will reduce.

Management's reasoning behind buying back may be that its shares are underpriced, i.e., the market price of the shares is lower than their intrinsic value.

Simply put, this is the share price that a rational investor is willing to pay at any given time. This value is found by discounting the expected earnings from that share.

If the market price of the share is $10, but the share's intrinsic value is $20, the market price does not reflect the share's actual value. The management would want to correct this discrepancy.

Repurchasing shares would increase the market price, possibly causing the market to reflect the claim's actual value.

The repurchase would also result in higher earnings per share and increased prices in the market. From the shareholder's point of view, a repurchase and a dividend payment are the same. An example would serve to illustrate this.

Example of a share buyback

MonkeyArmy Ltd. has generated a profit after tax of $1 million for this quarter and wants to use $500,000 to buy back its shares from the market. There are 20,000 shares outstanding in the market worth $100 each.

Option 1 - Pay a dividend of $15 per share

Option 2 - Repurchase the shares at $200 per share

We can calculate the earnings per share (EPS) as follows.


In the above case, Profit after tax stands at $1 million, and the firm has 20,000 shares. Therefore, the EPS (earning per share) is $50.

An assumption in a repurchase scenario is that the P/E ratio remains unchanged. Accordingly, the firm's price-to-earnings (P/E) ratio is as follows.


In the above case, the current market price is $100, and the EPS is $50 per share. Therefore, the P/E ratio is 2.

MonkeyArmy Ltd. wants to repurchase shares for $500,000. The repurchase price would be $200 per share. Thus, the company would repurchase 2,500 shares.

The total number of outstanding shares is now 20,000, less the 2,500 shares repurchased. Therefore, the firm has 17,500 outstanding shares.

Due to the repurchase, EPS would increase. The new EPS would be the quotient of the earnings of $1 million and the outstanding shares of 17,500. As a result, the EPS has increased to $57.14 per share.

Using the formula for the P/E ratio, we know that:


Therefore, the new market price would be the product of the EPS of $57.14 and the P/E ratio of 2. As a result, the market price would increase to approximately $115 per share.

We want to examine the effect of a share repurchase compared to that of a dividend payment.

Case 1 - The firm pays dividends of $15 per share. The market price stays at $100. The shareholder would receive $100 + $15 as a dividend, bringing their holdings to $115.

Case 2 - The firm repurchases its shares instead of paying dividends, increasing the market price to $115.

In either case, the shareholder receives $115 per share.

The total price of $15 at which shareholders are indifferent to dividends or buybacks is known as the equilibrium price.

The investor would prefer a dividend payment if the repurchase price provides less than a $15 price increase. Conversely, if the positive effect of the repurchase exceeds $15, the investor will lose out if he opts for a dividend payment.

We can calculate the equilibrium price using the below formula:



  • P1 = price after the repurchase
  • P0 = price before repurchase
  • N = number of shares outstanding before the buyback
  • R = number of shares repurchased   

If we apply this formula to the above example, where:

  • P0 = $100
  • N = 20,000 shares
  • R = 17,500 shares

The equilibrium price is approximately $115 per share.

What is the Dividend Payout (D/P) ratio?

Every year, the firm earns revenue from selling its goods or services. From the income, the business deducts all operating expenses, interest costs, depreciation and amortization costs, and taxes paid during the year.

The result is the Profit after tax. If there are any dividend payments to preference shareholders, the company deducts such dividend payments to arrive at the portion of the earnings that belong to equity shareholders.

At the discretion of management, these profits are either retained by the business or paid to the shareholders as dividends.

The dividend payout ratio is the percentage of these earnings paid to the shareholders in the form of dividends. Analyzing the firm's dividend payout ratio is critical because it helps address two questions.

  • Is the firm meeting its objective of wealth maximization?
  • Has the firm made sufficient provisions for financing its growth?

The primary objective of financial management is wealth maximization. Unfortunately, many firms focus on maximizing profits and fail to add shareholder value. A company can maximize shareholder wealth by maximizing share prices.

In the context of a dividend policy, a business can add value to its shareholders by adopting an optimal dividend policy. We will study such a policy in the upcoming sections through Walter and Gordon's models.

Certain firms are still in their growth stage and need significant investments to finance their expansion. For such firms, a high dividend payout ratio is not advisable.

Setting aside funds for growth purposes is also in line with the objective of shareholders' wealth maximization. This belief follows the dividend irrelevance theory, which we will also look at in detail.

Types of Dividend Policies

One of the primary considerations of dividend clientele is the stability of the company's dividends. Dividend clientele refers to the group of investors whose primary investment consideration is the firm's dividend policy.

For example, a young investor who has just begun to earn income and has nothing much to lose would not want regular income. Instead, he would prefer a company that invests in growth ventures.

Conversely, an aging investor would want periodic income and would, thus, prefer dividend payouts.

In the eyes of such investors, the less stable the dividend policy, the higher the risk associated with the business, and the less lucrative the investment.

Broadly, the firm can adopt any of the following dividend policies -

  1. It can periodically pay out a constant dividend.
  2. It can maintain a consistent dividend payout ratio.
  3. It can pay a continuous premium and reward shareholders with an additional prize in high-growth periods.

Stable dividend policy

In such a dividend policy, the business pays a fixed dollar amount to its shareholders, irrespective of the earnings at any given time. You guessed it right. The firm would pay dividends even in a loss-making scenario. Ouch!

Is it advisable for the firm to keep a fixed-dollar dividend at the same level for prolonged periods? Of course not.

When the firm's earnings reach a certain level every few years, and the business expects the revenues to stay at that level for a while, it increases the dollar dividend paid to shareholders.

Once the dollar dividend is increased, the business should stay at that dividend level for the foreseeable future, irrespective of earnings volatility.

The primary drawback of this policy is that, when the business is running massive losses, it would still have to pay its shareholders. Usually, the company sets aside reserves that would facilitate such payments.

Stable dividend payout ratio

In a stable dividend policy, the business would have a fixed dollar amount each year, say $5. As discussed, this would be detrimental to the firm's interests.

The firm can pay a fixed portion of its earnings yearly as a dividend. So, for example, it can decide that each year, it would pay out 25% of its net income as dividends.

Therefore, unlike a constant dollar dividend, firms that follow a stable dividend payout ratio will pay bonuses based on their earnings. The advantage of adopting such a policy is that it helps counter any volatility in earnings.

However, from the dividend clientele's point of view, such a policy may be counterintuitive to their objectives. In periods with extreme fluctuation in revenues, the incomes of such investors are uncertain.

Aside from the abovementioned approaches, the firm may adopt a third approach, wherein it pays a constant dollar dividend to its shareholders and an additional bonus in periods with solid earnings.

Dividend theories

In a previous section, we looked at the fundamental goal guiding the dividend payout policy of a firm, i.e., maximizing shareholders' wealth.

We will briefly look at the essence of the various schools of thought here and analyze them in detail in the coming sections. 

Some theories completely disregard the interrelationship between the value of a firm and the dividend policy it follows. According to these theories, dividends are nothing but a secondary decision.

Two revolutionary theories hold that dividends are integral to valuation and attempt to prove this by providing an operational justification.

Walter's theory holds that firms that can generate a rate of return on their investments greater than what shareholders could by reinvesting dividends retain their earnings, and vice versa.

Gordon's theory is an extension of the same principle but seeks to address some inherent flaws in Walter's theory. Let us now look at each of these theories in detail.

Irrelevance of dividends - Residual theory

Theoreticians have come up with three major decisions that financial managers must make:

  • Investment decisions
  • Financing decisions
  • Dividend decisions

However, according to the residual theory of dividends, the dividend decision is only secondary. It is a residual depending on the investment opportunities available to the firm at any given time.

If promising ventures are available for investment, the firm will choose to retain the earnings to finance these ventures. On the other hand, if there are no such opportunities, profits are paid out as dividends.

Therefore, available investment opportunities will decide whether earnings should be paid out as dividends.

The residual theory makes a significant assumption. It ignores the workings of the clientele effect and assumes that shareholders are open to benefit from capital appreciation and dividends.

So when does a company pay dividends?

  • Firstly, the company must shortlist those projects whose rate of return is greater than the firm's expected rate of return.
  • Only those projects with a positive net present value will be considered profitable among the projects selected.
  • After utilizing earnings to invest in these ventures, the firm will distribute the rest to shareholders as dividends.

Relevance of dividends - Walter's model

Certain other theoreticians believe that dividend decisions are a vital element in determining the firm's value.

James E. Walter was one of the biggest proponents of dividend relevance. But, like the residual theory, he, too, assumes that shareholders are indifferent to dividends and capital gains.

If the firm cannot generate a decent return on investment, the shareholders must have the option to reinvest these earnings elsewhere to generate a return greater than what the firm could.

Walter stresses an optimal dividend policy. This policy can be framed by studying the relationship between the firm's return on investment (r) and the shareholders' desired rate of return, which can be expressed as "ke".

The premise of the theory is as follows:

  • If the firm can generate a return greater than what the shareholders could (r > ke), it must retain its earnings.
  • If the firm does not have viable investment opportunities, and the shareholders can earn more than what the firm could by reinvesting the firm's earnings (r < ke), the firm must pay dividends.
  • If the return on the firm's investments equals the return on the shareholders' investments, the firm is indifferent to paying dividends or retaining earnings for reinvestment.

After all investment avenues are exhausted, the firm would pay out the rest of its earnings as dividends.

The model makes certain assumptions that have to be addressed:

1. You may ask, "Hey, if there are sufficient investment opportunities available, why doesn't the firm raise money through a public issue and pay out its earnings as dividends? Everyone wins, right?"

The very first assumption of Walter's model is that firms cannot raise money through an external issue. Businesses can only use retained earnings to finance growth.

2. No matter how many investments the company makes, its risk profile remains unchanged. This means that the firm's return on investment and the shareholder's expected rate of return would not change.

In reality, if the firm's risk complexion changes, the shareholders' expected rate of return would adjust. This is because shareholders would want a return proportional to the risk they adopt.

3. The business has a perpetual life.

Due to oversimplified assumptions, which do not hold water in today's markets, its conclusions are questionable. The model also ignores the operation of the clientele effect, which better explains firm valuation.

Relevance of dividends - Gordon's model

Gordon's model attempts to fix some of the flaws apparent in Walter's hypothesis. This theory was proposed by Myron J. Gordon, a staunch proponent of the dividend relevance hypothesis.

The premise of this theory is that investors are rational and wish to avoid uncertainty. Shareholders, therefore, prefer current dividends over future dividends.

Gordon's train of thought is similar to the belief that "A bird in the hand is worth two in the bush." If the firm decides not to pay dividends and, instead, finance future growth, it would have an impact on share prices.

This translates to the fact that the higher the retention rate, the more the investors would "penalize" the share price by discounting them. The lower the retention ratio, the higher the share price.

The retention ratio is the inverse of the dividend payout ratio. For example, if the D/P ratio is 10%, the retention ratio is 90%. The retention ratio is denoted as "b".

The growth rate is measured as the product of the retention ratio (b) and the rate of return on the firm's investments (r).

The assumptions of Gordon's model are similar to those of Walter's, with a few differences. Like Walter's model, Gordon's model assumes that the firm cannot finance its growth externally. The firm is assumed to have a perpetual life.

It also assumes that "r" is constant. However, the key difference between the two models lies in the assumption in Gordon's model that shareholders' expected rate of return, ke, increases with retention rate.

This is because a higher retention rate signifies uncertainty in dividends to the shareholders, and the shareholders would want additional returns to justify this risk.

It is assumed the firm does not change its retention ratio. Gordon calculates the price of a firm's share as follows:



  • p0 = Current Price of the share
  • d1 = Dividend per share paid to shareholders
  • ke = Shareholders' expected rate of return
  • br = Growth rate, which is the product of retention rate (b) and rate of return on the firm's investments (r)

From this, we can derive another assumption of the model. "Ke" must always be greater than "or", as the price of the share cannot be negative.

Let us take a numerical example to justify Gordon's model.

MonkeyArmy Ltd. has an earnings per share (EPS) ratio of $20. It generates a 10% annual on its investments. Under different scenarios of the dividend payout ratio, we can examine Gordon's model.

For each scenario, the shareholders' expected rate of return (ke) decreases as the dividend payout ratio increases. The Dividend per share (DPS) is calculated as the product of the D/P ratio and earnings per share (EPS).

Scenario D/P ratio (%) Retention ratio “b” (%) Ke (%) assumed r (%) b * r (%) DPS ($)
A 10 90 10 10 9 2
B 20 80 9 10 8 4
C 30 70 8 10 7 6
D 40 60 7 10 6 8
E 50 50 6 10 5 10

Now that we have all the variables, using the formula explained above, we can prove that, as the retention ratio decreases, the share price increases.


Scenario Retention ratio Price of the share ($)
A 90 200
B 80 400
C 70 600
D 60 800
E 50 1000

As you can see, the price of the share keeps increasing as the retention ratio increases.

Researched and authored by Sathyanarayana Sairam | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

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