Corporations pay dividends as a way to share the company's profits with the shareholders. Companies are under no obligation or regulation to calculate their dividend payout a certain way. Investors should understand the dividend policy and philosophy of the stocks they own.
The decision to pay a dividend is at the discretion of a company's board of directors. Companies can elect to pay dividends quarterly, twice a year, annually or not at all. The amount of a dividend payout is usually related to a company's net income or free cash flow. Some boards adopt a regular dividend policy and other will pay a distribution only when they believe it is in the interest of the company and shareholders.
For companies with a regular dividend policy, investors can look at the dividend payout ratio. A sustainable dividend policy requires that the company have enough net income to support the payout. The ratio is calculated by dividing the dividend rate by the net income per share. For example, if Company A pays a $1dividend each quarter and has a net earnings per share for the quarter of $2, the dividend payout ratio is 50 percent.
Some types of stocks will have a higher payout ratio, sometimes even exceeding the net income per share. Real estate investment trusts (REITs), master limited partnership (MLPs) and capital intensive companies, including leasing and shipping companies, may have high-dividend payouts in relation to their net income. REIT and MLP stocks are required by tax law to pay a majority of their cash flow as dividends. Other high-dividend companies also have high depreciation amounts on their equipment, making free cash flow a more important measurement than net income when evaluating dividend payouts.
A stock's dividend yield is calculated by dividing the annual dividend payout into the stock share price. If a stock pay a 25 cent dividend quarterly and the stock is at $50, the dividend yield is $1 divided by 50 or 2 percent. The dividend yield number is only valid for companies with a regular, stable dividend payout.
Many companies will increase their dividend as the company grows and net income increases. These types of companies can provide significant long term investment growth. The Standard & Poors list of Dividend Aristocrats is a listing of companies that have increased their dividend payouts for at least 25 consecutive years. These are companies with a dividend policy dedicated to rewarding investors.