Definition
The Residual Dividend Model is a method a company uses to determine the dividend it will pay to its shareholders.
Companies which use retained earnings to finance new projects use this method. The company first determines which new projects it wants to finance, dedicates funds to those projects, and then distributes any leftover profits to its shareholders as dividends.
This model can lead to unpredictable and inconsistent dividend returns for the investor. However, the company's goal is to generate further profits from the projects it funds, which benefits the shareholders overall.
Irrelevance of Dividends
The Residual Dividend Model is an outgrowth of The Modigliani and Miller Theory that posits that dividends are irrelevant to investors. This school of thought believes that investors do not state any preference between current dividends and capital gains. It goes on to say that dividend policy does not determine market value of a stock. Accordingly, the shareholders are indifferent to the two ways by which their investment grows:
- receiving a dividend
- share price increasing due to retained earnings
What investors want are high returns - either in the form of dividends or in the form of re-investment of retained earnings by the firm .
Writing a check.
Companies usually issue investors a check for their dividend.
Dividend or Capital Gain Trade-Off
The Residual Model dividend policy is a passive one and, in theory, does not influence market price because the same wealth is created for the investor regardless of the dividend. The firm paying out dividends is obviously generating income for an investor; however, even if the firm diverts some earnings for investment opportunities, the income of the investors will rise later, assuming that those investments are profitable. The dividend, therefore, fluctuates every year because of different investment opportunities and earning levels.