A company’s dividend policy determines how dividends are paid out to shareholders. Companies that follow a residual dividend policy use profits to fund operations first, then pay out any remaining or residual amounts to investors. If you’re investing for dividend income, it’s important to understand how payout policies work. A financial advisor may also be able to provide context and information on how you should think about residual dividends. SmartAsset’s free advisor matching tool can help by matching you with advisors that serve your area.
What Is a Dividend Policy?
A dividend is a percentage of a company’s profits that is paid out to shareholders. Dividends are more common with established companies and they’re often used as a means of rewarding current investors for their loyalty and/or attracting new investors. Growth companies are less likely to pay dividends, as they tend to reinvest profits.
To receive a dividend from a company, you must own shares before its ex-dividend date. This is the date the company uses to establish ownership of shares in order to determine who receives an upcoming dividend payment. The company’s dividend policy determines how profits are divided up among shareholders.
Specifically, a dividend policy dictates when dividends are paid, how much is paid out to investors and what form the dividend payouts take. It’s possible to receive dividends as cash or stock and some companies also offer the option of an automatic dividend reinvestment plan (DRIP). A DRIP makes it easy to use your dividends to purchase additional shares of the same stock.
Residual Dividend Policy Explained
A residual dividend policy calculates dividends paid to shareholders, based on the amount of profits remaining after capital expenditures have been paid. Companies that pay residual dividends use cash flow to cover expenses first, then pay dividends to shareholders from the amount that’s left over.
So why would a company choose a residual dividend policy? This type of approach to dividends allows the company to meet its expenses while still meeting the expectations of its shareholders. The dividend received may increase or decrease over time as the company’s cash flow fluctuates. But if you’re a buy-and-hold investor, you may not be as concerned with short-term ups and downs.
Companies that pay residual dividends are under less pressure to finances operations with debt. The company can pay expenses from profits, allocate funds to future expansion projects and still pay out a dividend to shareholders. This type of policy also allows the company to decide what percentage to pay out in residuals.
Residual Dividend Policy vs. Other Dividend Policies
The residual dividend strategy is just one approach companies can use when shaping dividend policy. There are three other options for paying dividends:
- Stable dividend policy
- Constant dividend policy
- Hybrid dividend policy
With a stable dividend policy, shareholders in a company are paid dividends on a regular basis according to the payout schedule. The amount of the dividend isn’t fixed and can increase or decrease from one payment period to the next. But the payments are continuous and guaranteed. With a residual dividend policy, receipt of dividends is dependent on there being something left for the company to pay once expenses have been covered.
A constant dividend policy involves paying out a percentage of earnings as dividends annually. What this means for investors is that a larger dividend may be forthcoming in years when earnings are higher. Conversely, dividends may shrink or disappear altogether in years when earnings are lower. This type of dividend strategy may be better suited to investors who are more comfortable with risk.
A hybrid dividend policy combines features of the stable and residual approaches. So there might be a regular dividend payment that investors can count on and the possibility of a second residual dividend payment, though it’s not always guaranteed. This type of dividend policy is less common, though you may see cyclical companies offer them.
Which Dividend Policy Is Best?
The best dividend policy is the one that allows you to collect dividends in a way that aligns with your investment goals. If you’re investing for the long-term and you’re interested in generating consistent income from dividends, then a stable payout policy may work best. Stable dividend policies are the easiest for companies to implement and are the most commonly used strategy for paying dividends.
If you’re more tolerant of risk, a constant dividend policy could potentially result in higher dividend payouts. There is, of course, the possibility that you wouldn’t see any dividends at all in certain years. If the market were to experience an extended downturn, for example, that could wipe out dividends temporarily.
The residual dividend model might be attractive if you want to invest in companies that are focused on increasing profitability long-term. Since the company is less likely to turn to debt to fund operations and covers expenses before paying dividends, that can increase its financial stability over time.
How To Invest for Dividends
If you’d like to add dividend-paying stocks to your portfolio, getting started is as simple as opening a brokerage account online if you don’t already have one. From there, you can research individual stocks to determine:
- Which type of dividend policy the company follows
- How much they typically pay in dividends
- When those dividend payments are made
You can then decide which companies to invest in, based on your own dividend goals. If you need current income, for example, then you might want to lean toward companies that pay stable dividends. Or you may want to choose a company that allows you to automatically reinvest dividends into additional shares so you can grow your position without additional out-of-pocket cash.
When comparing companies, don’t focus solely on the dividend yield. Also, consider how sustainable the dividends are likely to be over time. A high dividend can be misleading if a company is only offering it to attract new investors in an attempt to solve cash flow problems. So taking a closer look at the fundamentals, such as price-to-earnings ratio (P/E), earnings per share (EPS) and debt to equity.
A residual dividend policy allows companies to balance meeting expenses with keeping shareholders satisfied. But it’s possible that you may receive a lower payout than expected if there are fewer residual profits to go around. Investing in companies that use a residual dividend policy alongside stable or constant dividend strategies can help you to manage that risk.
Tips for Investing
- Consider talking to your financial advisor about residual dividends and how to choose the right dividend stocks based on your needs and goals. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When investing for dividend income, it’s important to remember that those payouts are taxable. In order for dividends to be qualified and thus, taxed at the more favorable long-term capital gains tax rate, you’ll need to hold the underlying shares for a minimum of 61 days in the case of common stock or 91 days for preferred stock.
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