Companies consider several key factors in establishing a dividend policy. In general, it has to weigh the benefits of retained earnings versus those of paying out dividends to shareholders. Companies take differing approaches to dividend policy. Some never pay dividends. Others pay them periodically. Some companies routinely and consistently pay dividends.
Dividend Policy Basics
A dividend policy is a company's approach to paying dividends to shareholders. Dividends are payouts of company earnings to shareholders based on the number of owned shares. At the core of a company's dividend policy are two basic options for how to handle earnings. A company can choose to retain most or all earnings for reinvestment or it can pay earnings to shareholders as regular income.
Retained Earnings Considerations
Companies typically retain earnings when leaders see more value in reinvesting profits than in paying out dividends. Generally, companies that are newer and in early growth stages have more reason to reinvest. Additionally, companies that have chosen to enter new markets or to investment in new business developments may need to retain earnings to invest in implementation of those strategies. If the long-term return on investing earnings justifies not paying dividends, shareholders are generally accepting. Shareholders may view dividends in lieu of reinvestment as a sign the company's growth potential has stalled, according to Alex Tajirian in his "Dividend Policy" overview.
Dividends are an incentive to retain existing shareholders and to entice new shareholders. Some investors strongly value dividend income as part of their investment approaches. When a company pays dividends, it believes the value of rewarding shareholders with profits is greater than the value of reinvesting the money in other opportunities. Regular dividend payments show a company's leadership has faith enough in the company's stability to pay out extra cash to shareholders.
Tajirian also points out that a company has a legal obligation to pay out dividends when it has extra cash and no sensible way to reinvest it. Shareholders are the owners of a publicly owned company and are entitled to a share of profits if company leaders cannot justify retaining earnings to expand the company. Obviously, shareholders would have to demonstrate that the company withheld earnings without justification if a complaint came about.
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