The ratio of dividend to earnings is known as payout ratio. Some companies may follow a policy of constant payout ratio, i.e., paying a fixed percentage of net earnings every year. With this policy the amount of dividend will fluctuate in direct proportion to earnings. If a company adopts a 40 per cent payout ratio, then 40 per cent of every rupee of net earnings will be paid out. For example, if the company earns Rs. 2 per share, the dividend per share will be Re 0.80 and if it earns Rs. 1.50 per share the dividend per share will be Re 0.60. This policy is related to a company’s ability to pay dividends. If the company incur losses no dividends shall be paid regardless of the desires of shareholders. Internal financ-ing with retained earnings is automatic when this policy is followed. At any given payout ratio, the amount of dividends and the additions to retained earnings increase with increas-ing earnings and decrease
with decreasing earnings. This policy simplifies the dividend decision, and has the advantage of protecting a company against over or under payment of dividend. It ensures that dividends are paid when profits are earned, and avoided when it incurs losses.
Small Constant Dividend Per share Plus Extra Dividend
Under the constant dividend per share policy; the amount of dividend is set at a high level, and the companies with stable earnings usually adopt this policy. For companies with fluctuating earnings, the policy to pay a minimum dividend per share with a step-up feature is desirable. The small amount of dividend is fixed to reduce the possi-bility of ever missing a dividend payment. By paying extra dividend (a number of compa-nies pay an interim dividend followed by a regular final dividend) in periods of prosperity, an attempt is made to prevent investors from expecting that the dividend represents an increase in the established dividend amount This type of a policy enables a company to pay constant amount of dividend regularly without a default and allows a great deal of flexibility for supplementing the income of shareholders only when the company’s earnings are higher than the usual, without committing itself to make larger payments as a part of the future fixed dividend. Certain shareholders like this policy because of the certain cash flow in the form of regular dividend and the option of earning extra dividend occasionally.
When have discussed three forms of stability of dividends. Generally when we refer to a stable dividend policy, we refer to the first form of paying constant dividend per share. A firm pursuing a policy of stable dividend may command a higher price for its shares than a firm, which varies dividend amount with cyclical fluctuations in the earnings.
Significance of Stability of Dividend
The stability of dividends has various advantages from the point of view of shareholders as well as company. They are:
• Resolution of investors’ uncertainty.
• Investors’ desire for current income.
• Institutional investors’ requirements.
• Raising additional finances.