A firm can do one of two things with profits: 1) reinvest them--in which case they are counted as retained earnings; or 2) give them to shareholders in the form of dividends. A firm's dividend policy describes the firm's plan regarding both the amount and timing of dividends. Although by no means the only possible policy, a constant nominal dividend policy is the worldwide standard.
Constant Nominal Dividends
When a firm adopts a constant nominal dividend policy, it intends to pay a dividend of the same dollar amount per share at regular intervals. For instance, ABC Inc. may decide to issue a quarterly dividend of $5 per share. Once per quarter, every shareholder of ABC Inc. would receive a payment equal to $5 times the number of shares owned. The shareholder may receive this dividend as cash or, in most cases, may choose to reinvest the dividend in stock of ABC Inc.
Other Dividend Policies
Although constant nominal dividend policies are the norm, firms do have other choices. The two most common alternatives are a constant payout dividend and a low-regular-and-extra dividend. Under the former, a firm pays a dividend that is fixed as a percentage of earnings; under the latter, a firm pays a small, regular dividend that may be supplemented by larger dividends when earnings warrant.
Just because a firm adopts a particular dividend policy does not mean that it is legally bound to this policy. For instance, Microsoft did not pay dividends for many years, then issued a series of surprise dividend announcements starting in 2003. Also, state laws legally prohibit firms from paying dividends that exceed "legal capital"--typically defined as the par value of common stock. The intent of these "capital-impairment restrictions" is to preserve capital in order to protect bondholders, who are the first creditors to be repaid in the event that the firm goes bankrupt. There are, however, no legal prohibitions against paying dividends greater than current earnings. Thus, a firm with sufficient capital will be able to maintain a constant nominal dividend policy despite periods of low earnings or even losses.
Irrelevance of Dividends
In light of their potential to move stock prices, perhaps the most puzzling thing about dividends is their theoretical irrelevance. Modigliani and Miller proved that in a world with perfect capital markets, a firm should be able to issue whatever dividend it pleases without affecting profits or stock prices. Yet the financial world does not always conform to the theory of dividend irrelevance. For example, Microsoft's stock rose on the surprise news of its 2003 dividend.
Theorists have proposed a number of possible explanations for the real-world relevance of dividends. Most of these theories revolve around the fact that investors do not always trust firms to uphold their commitment to distribute profits to shareholders. One way to view a dividend policy is as a formal signal that the firm intends to share profits with stockholders. Thus, a constant nominal dividend policy is a non-binding promise to pay a fixed dollar amount per share at regular intervals.
Jesse Czelusta has been writing about investment topics since 1999. His articles and research have appeared in World Bank reports, "Challenge," "The Journal of Economic History" and MarketWatch. Czelusta is the co-editor of Index Rx, an exchange-traded fund newsletter. He holds a Doctor of Philosophy in economics from Stanford University.