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Dividend University

Dividend Policies Explained

Dividend stocks have a large and devoted following in the investment community. There is good reason for this: historically, dividends have been a major contributor to total returns in the stock market. In fact, in a study conducted by Guinness Atkinson Asset Management, reinvested dividends composed over 90% of total S&P 500 returns from 1940-2011. The discrepancy between dividend stocks and non-dividend stocks over that 71-year period is stark. Dividend stocks in the S&P 500 Index generated an 8.8% annualized return in that time. By comparison, non-dividend stocks returned just 1.7% per year.

The impact of dividends is clear. If an investor had invested $100 in the S&P 500 at the end of 1940 and reinvested dividends, they would have had approximately $174,000 by the end of the survey period. But without those dividends, they would have just $12,000.

As a result, it is no surprise that investors care deeply about dividends. Companies carefully manage their dividend policies, but not all dividend programs are created equal. There are various forms of dividend programs that companies can have. This article will discuss the three major types of dividend policies, along with examples of each.

The Dividend Stability Policy

Under the dividend stability policy, dividends are set as a percentage of a company’s annual earnings. As a company’s earnings per share fluctuates up or down, so will the dividend. For most companies, the goal is to increase earnings each year, and as such the dividend should increase each year as well. The tobacco industry commonly employs the dividend stability policy.

For example, Altria Group (MO ) tells its investors that it expects to distribute 80% of the company’s adjusted earnings per share each year. Altria generates very high returns on capital and free cash flow, and along with its strict cost controls, it has little trouble growing earnings each year. This results in steady dividend growth. The company paid $2.17 per share in dividends in the past four quarters combined, which is approximately 81% of its trailing 12-month earnings per share.

The Residual Dividend Policy

Equity holders are considered residual claimants on a company’s earnings. Put simply, shareholders are owners of a small piece of a company, and as such they are entitled to the leftover profits after all expenses are paid and after bondholders and preferred equity holders are compensated.

Under the residual dividend policy, dividend payments come from residual equity after expansion investments are satisfied. Many companies seek to maintain a set debt-to-equity level. Energy companies frequently operate under this model as the oil and gas industries require managers to keep long-term focus in planning growth capital expenditures each year. Tapping the equity markets is often utilized to pay current distributions, but the downside is that the dividends can be meaningfully reduced if the capital markets become uncooperative.

For example, suppose a company generates $1 billion each year in earnings and wants to maintain a 50% debt-to-equity ratio. Also assume that the company needs $900 million next year for growth expenses. If the company wants to hold the 50% ratio, it would finance the projects with $600 million in equity and $300 million in debt. The $600 million in equity financing would leave $400 million for dividend distributions.

The Hybrid Dividend Policy

The final method is called the hybrid dividend policy because it is essentially a blend of the stability and residual dividend policies. Here, companies will still utilize traditional metrics like debt-to-equity but through a longer-term lens. They do not stick so rigidly to quarterly debt-to-equity metrics as the sole gauge of what one quarter’s dividend will be.

Companies in cyclical industries tend to adopt the hybrid policy. Since business economics can fluctuate, they will pay a modest regular dividend that can be easily maintained, plus the potential for a supplemental dividend if business conditions are generally good. For example, from 2006-2008, steel company Nucor (NUE ) paid a regular quarterly dividend and a special quarterly supplemental dividend. In 2008, when the recession hit, the company eliminated its special dividend but maintained its 35-cent per share regular dividend. The company has continued to raise its regular dividend to its current level of 37.5 cents per share.

The Bottom Line

Income investors who are looking for dividend stocks to buy should first understand the various forms of dividend policies. It is easy to assume all dividend programs are the same but that is not the case. Across different industries, companies have different financing needs. As a result, there are a few major dividend programs employed to both service a company’s ongoing operations and reward shareholders with dividends.

Over time, dividends and dividend reinvestments have made up a significant portion of the stock market’s total return. History has proven that dividend investing is a profitable endeavor. Income investors should review the intricacies of the dividend stability, residual dividend, and hybrid dividend models.