Dividend policy, a critical aspect of corporate finance, has witnessed significant shifts in recent years. Prominent business houses, both globally and in India, are increasingly adopting a residual dividend policy, a strategy that prioritises investment in growth opportunities before distributing profits to shareholders. Let us look at the evolving trends in dividend policy, the rationale behind the shift towards residual dividends, and its implications for investors.

Dividend paid by the company is not an expense in accounting terms, rather it is an appropriation of profits to the owners of the company. Dividend is always paid as a percentage on the face value of the share. As per the SEBI’s current Listing Obligations and Disclosure Requirements it is mandatory for every company to disclose their dividend policy in their annual report and website. Traditionally, companies adhered to stable dividends, aiming to provide consistent payouts to shareholders. However, the dynamic business environment, characterised by rapid technological advancements and evolving market conditions, has prompted a re-evaluation of this approach. Residual dividend policy, which emphasises reinvesting profits into the business to fuel growth, has gained traction among major corporations.

At its core, residual dividend policy entails prioritising capital expenditures and working capital requirements. After these financial obligations are met, any remaining profits, or residuals, are distributed to shareholders as dividends. This approach aligns with the company’s growth objectives, ensuring that sufficient funds are available for reinvestment in profitable ventures.

Rationale behind the shift

The shift towards residual dividend policy is driven by several factors. It allows companies to reinvest a larger portion of their earnings into growth opportunities, such as research and development, capital expenditures, and acquisitions. This could lead to higher long-term profitability and increased shareholder value. Further, this policy provides flexibility in dividend payouts.

If a company has lucrative investment projects, it could allocate more funds towards it, while reducing dividends. Conversely, if investment opportunities are limited, it can distribute more dividends. Investors often perceive companies with residual dividend policies as financially disciplined and focused on long-term growth, which can boost investor confidence.

An examination of top business houses reveals a clear trend towards residual dividend policy. Companies like Reliance, TCS, and others have consistently prioritised reinvestment in their businesses, resulting in substantial growth and shareholder value creation. Further, tech companies, distribute a relatively small portion of their earnings as dividends, opting to allocate a significant portion towards research and development, and acquisitions. While residual dividend policies offer several benefits, it is important to consider their potential drawbacks. Dividend payouts can vary significantly year to year, which may not be attractive to investors seeking consistent income. Fluctuating dividends could confuse investors who are looking for stable dividend.

The adoption of residual dividend policy has significant implications for investors. While it may result in fluctuating dividend payouts, it could lead to long-term capital appreciation as the company’s investments drive growth and profitability. Investors seeking stable income may prefer companies with established dividend track records, but those with a longer-term investment horizon may find companies who adopt residual dividend policy, more appealing.

As companies focus on innovation, growth, and long-term sustainability, residual dividend policy has emerged as a strategic tool for achieving these objectives.

Saravanan is a professor of finance and accounting at IIM Tiruchirappalli and Williams is the Head of India at Sernova Financial