A dividend policy is the parameters used by a board of directors as the basis for its decisions to issue dividends to investors. A well-defined policy addresses the timing and size of dividend issuances, which can be a major part of a company's outgoing cash flows.
When a company has followed a consistent revenue and earnings growth path, a reasonable proportion of its investors are probably investing in the company to take advantage of the increases in its stock price that are caused by company growth.
A rapidly growing company is presumed to need all of its cash to fund growth, so no dividend is expected. Once the company issues a dividend, these growth-oriented investors will assume that the company is not planning to grow as fast, and so will sell the stock. They will be replaced by a different group of investors who are more interested in earning dividend income.
The change in the type of investor is neither good nor bad, but it does mean that there will be an increased amount of turnover among shareholders for a period of time. During this transition period, it is possible that the share price will be somewhat more volatile than usual.
If the board wants to find a use for the company’s excess cash, but does not want to turn away its growth-oriented investors, then alternative uses for the cash are making acquisitions or paying off liabilities.
If the board of directors elects to go forward with an initial dividend payment, it is of considerable importance to signal to the marketplace that the company intends to continue to issue dividends at regular intervals. Otherwise, a one-time distribution to shareholders via a dividend will merely send the growth investors to the exits without creating an incentive for income investors to take their place, thereby creating downward pressure on the stock price.
When embarking on a strategy of issuing ongoing dividends, it is of some importance to begin with a small dividend that the company can easily support from its current resources and expected cash flows. By doing so, the board can comfortably establish a gradual increase in the size of the dividend that the investment community can rely upon, which should result in a slow increase in the price of the company’s stock. Conversely, the worst type of dividend is one that is so large that the company has a difficult time scraping together the cash needed to pay it, which can endanger the ability of the company to operate on an ongoing basis.
It is also useful for the board of directors to consider the negative implications of not having sufficient cash to continue paying a dividend. If this were to happen, the income-oriented investors who are holding the stock precisely because of those dividends will sell their shares; this will trigger a supply and demand imbalance that will lower the price of the stock. Eventually, value-oriented investors will buy the stock when it has dropped by a sufficient amount, in hopes of a recovery in the stock price. Nonetheless, a dividend cancellation almost always triggers a steep stock price decline.
In summary, the board of directors should think long and hard about the decision to begin issuing dividends. Dividends work best when followed consistently over a long period of time, but doing so requires rock-solid cash flows. Any inability to meet a dividend obligation will trigger a rapid stock price decline. Thus, always consider a vote to issue dividends as a long-term strategic issue, not just a short-term payout.