Modern firms have a wide range of dividend policies, impacting their investors. The differences in these policies lead to different expected returns and therefore varying degrees of risk for investors. As an investor, you should know the factors influencing dividend policy. This keeps your money in line with your investment strategy for optimal portfolio performance.
Centralized ownership tends to favor high dividend payments, while decentralized ownership tends to favor low dividends. This is because high dividends appeal more to investors with a non-controlling stake in the firm, whereas low dividends are allowed for those with controlling stakes. As a result, firms that operate with decentralized ownership will or tend to pay higher dividends.
A firm’s market capitalization often dictates dividend policy in today’s market. Generally, firms with higher market caps will pay higher dividends than firms with smaller market caps. As a result, investors tend to look for firms in the highest 10-best sectors and industries that pay very high dividends and avoid those that don’t pay very high dividends at all.
Expectations from the Firm
Firms which are expected to record strong growth in the future are likely to pay high dividends. This is because investors feel that their investment in those firms will more than recoup the dividend payment. Conversely, when expectations for growth are low, investors may expect a lower dividend payment or even no payment, regardless of the firm’s ownership structure or market capitalization.
Earnings per Share (EPS) Growth Rate
Regardless of the ownership structure and market capitalization, a firm’s EPS growth rate influences its dividend payment. For example, a firm expected to increase its EPS by X% in the following year will pay a dividend of Y%. However, a firm with lower or negative expectations for growth may choose to forego dividends altogether. This can be because investors’ investment risk is low or there are no expected EPS growth prospects for the firm (e.g., due to a low market capitalization).
While owning a stock, investors typically look for stocks that pay dividends higher than what they pay in interest. This drives the share price, and the yields paid to shareholders are driven lower. As a result, firms that pay very high dividends tend to have low or negative yields. Investors also try to avoid paying high dividends if the firm’s share price is likely to fall following a dividend payment.
Dividend Policy of the Firm’s Competitors
The dividend policy of the company’s competitors often influences investors’ expectations and sales growth rate. Investors compare firms’ dividend policies by looking at their relative cash flows and views on future earnings to determine which firms will pay high dividends or, conversely, pay low dividends so that they can all afford to pay them. Competitors’ dividend policies also influence investor expectations of future earnings.
The expected impact of regulations on the firm’s bottom line can lead to changes in dividends paid. For instance, if new regulations that increase the cost of doing business are expected, investors may expect lower dividends or no dividends at all until such time that those costs are more fully understood and can be passed on to customers or absorbed by the firm.
Firms with higher tax burdens are not likely to pay high dividends. This is because investors do not want to pay taxes on the dividends they receive from their investments, so firms that pay higher dividends often have lower tax burdens.
Tax Status of the Firm
Dividends may be taxed differently from other forms of profit distributions. As a result, the firm’s tax status can affect how much it will pay as dividends, affecting investors’ expectations and estimation of the risk involved with holding onto shares of a given stock.
Rate of Return on Assets (ROA)
If ROA rises, investors may expect dividends to be paid at higher rates. Conversely, if ROA is expected to fall, investors may expect lower dividends or no dividends if a firm fails to generate sufficient cash flow from its operations.
Larger firms can afford higher dividends than smaller ones because of their greater size and scale economies on which their high profits can be based. In addition, these larger firms enjoy economies of scale in operations, allowing them to conduct more activities at lower unit costs than smaller firms, which can be seen as differentiating factors of the companies.
Therefore, a small firm may only produce one product or service, but a large firm can produce more variety of products and services in the same amount of time. Hence, they enjoy economies of scope, which make them able to take better advantage of economies of scale.
The bottom line is that dividend policy is closely tied to a company’s stock price. It is, therefore, crucial to consider dividend policy and its effect on the overall success of a firm. As such, it is important to consider the real factors that affect firm performance and the subjective factors that affect dividend policy. Understanding each of these will help an investor make better investment decisions.