The phrase “the dividends check is in the mail” is one of the simplest methods for businesses to convey their financial health and shareholder value. Dividends, those regular cash transfers from earnings to owners that many companies make, convey a strong, unmistakable statement about the future prospects and success. Good indicators of a company’s fundamentals are its willingness, capacity, and capacity to boost dividends over time.
KEY LESSONS
Regular dividend payments—also known as cash distributions—help a company’s shareholders understand its underlying health and durability.
In general, older, slower-growing businesses choose to distribute dividends on a regular basis, whereas younger, faster-growing businesses prefer to reinvest the proceeds in their business.
A greater yield is more appealing, while a yield that is lower can make a stock appear less competitive in relation to its industry. The dividend yield calculates how much revenue has been earned in relation to the share price.
A crucial indicator of a company’s health is the dividend coverage ratio, which is the ratio of earnings and the net payout shareholders receive.
Companies with a history of increasing dividend payments that abruptly reduced them may be experiencing financial difficulties, as may similar, older companies that are hoarding large amounts of cash.
Dividends Signal Principles
Dividend payments were one of the few indicators of a company’s financial health prior to the 1930s, when firms were legally forced to publish their financial information. Dividends continue to be a valuable barometer of a company’s future notwithstanding the Securities and Exchange Act from 1934 and the additional openness it brought to the sector.
Dividends are typically paid by mature, prosperous businesses. Companies that don’t pay dividends may nevertheless be profitable, though. A corporation will frequently maintain its profits and put them back into the company if it believes that its own growth prospects are superior to those of other investment possibilities accessible to shareholders. Few “growth” corporations pay dividends as a result of these factors. However, even mature businesses must keep enough cash on hand to cover operating expenses and deal with unforeseen circumstances, even when a large portion of their income may be given as dividends.
Dividend Illustration
The evolution of Microsoft (MSFT) over its life cycle shows how dividends and growth are related. No dividends were paid when Bill Gates’ creation was a high-flying, expanding business; instead, all profits were reinvested to support future expansion.
This 800-pound software “gorilla” eventually reached a limit where it was unable to continue expanding at the incredible rate it had done for so long.
In order to keep investors interested, the corporation started using dividends and share buybacks rather than rewarding investors through capital appreciation. In July 2004, about 18 years following the company’s IPO, the plan was revealed.
Through an innovative 8-cent quarterly dividend, and a $3 one-time payout, and a $30 billion share repurchase program over four years, the cash distribution plan gave investors access to approximately $75 billion in value.
With a yield of 0.87%, the company will still be paying dividends in 2022.
The Yield of Dividends
A dividend yield, which is determined by dividing the yearly dividend income per share by the stock’s current share price, is a popular measurement among investors. The quantity of income earned in relation to the share price is measured by the dividend yield. When a company’s dividend yield is low compared with other companies in its industry, one of two things may be true: either the stock price is high as the market believes the company has promising future prospects and is not overly concerned about the business’s dividend payments, or the company is in financial trouble or cannot afford to pay appropriate dividends. However, a corporation with a high yield on dividends may also be exhibiting signs of illness and a declining share price.
Because retained earnings will be invested in growth prospects, as we described above, and result in returns for shareholders in the form of equity gains (think Microsoft), the dividend yield is of minimal significance when evaluating growth businesses.
While a high dividend yield is typically a good thing, it can occasionally be a sign that a company is struggling financially and has a low stock price.
Ratio of Dividend Coverage
Consider if a corporation is able to pay the dividend when assessing its dividend-paying policies. Dividend coverage, a ratio between the profits of a business and the net payout paid to shareholders, is still a popular way to assess if earnings are high enough to pay dividend obligations. Earnings every share divided by dividends per share is how the ratio is computed. There is a significant chance of there being a dividend cut when coverage is getting thin, which might have a disastrous effect on value. A cover ratio of two or three will provide investors peace of mind. In reality, though, the coverage ratio only starts to matter as a warning sign when it drops below 1.5, which is also the point at which prospects start to appear dangerous. If the ratio is less than 1, the corporation is paying this year’s dividend from last year’s retained earnings.
At the same time, if the payment increases much, let’s say to 5, investors might consider whether management is holding back extra profits and underpaying shareholders. By increasing their payouts, managers are indicating to investors that they anticipate solid business conditions for the next year or more.
Fearful Dividend Cut
Investors should take any sudden reduction in dividend payments by a company that has a history of steadily rising dividend payments as a warning sign that trouble is about to arise.
Investors should be cautious of businesses that rely on loans to finance those payments, even though a history of consistent or rising dividends is undoubtedly comforting. Consider the utility sector, which previously drew investors in with steady profits and big payouts. Some of those businesses had to incur more debt since they were investing money in growth prospects while attempting to keep dividend levels the same. Be wary of businesses with debt-to-equity ratios higher than 60%. Increased debt levels frequently result in stress from Wall Street and debt-rating agencies. In turn, that may make it more difficult for a business to distribute dividends.
Excellent in discipline
The decision-making process for management’s investments is made more disciplined by dividends. It’s possible that holding onto profits will result in exorbitant CEO salaries, poor management, and inefficient asset usage. According to studies, a corporation is more likely to overpay for purchases and hence reduce shareholder value the more cash it retains. In actuality, businesses that pay dividends typically employ capital more effectively than comparable businesses that don’t. Companies which issue dividends are also less inclined to falsify their financial records. Let’s face it: Managers may be incredibly inventive when it comes to presenting profitable results. But manipulation is made far more difficult by the fact that dividend commitments must be met twice a year.
Dividends are also a form of public promise. Breaking them is bad for share prices and embarrassing for management. To delay boosting dividends, let alone suspending them, is viewed as a failure confession.
Investors may find it easier to sleep at night if they receive a dividend check as proof of prosperity. While earnings on paper may indicate one thing about a business’s prospects, profits that result in dividend payments indicate something entirely different.
A Method of Value Calculation
Another reason dividends are important is that they can help investors determine the true value of a firm. The capital asset pricing model, which serves as the cornerstone of corporate finance theory, is built around the dividend discount model, a standard formula for determining a share’s intrinsic value. A share is valued by the total of all of its potential payouts for dividends, “discounted back” into its net present value, in accordance with the model. Dividends are an essential indicator of a company’s worth because they represent a type of revenue to the investor.
It’s vital to remember that equities with dividends have a lower likelihood of rising to unsupportable levels. Dividends have been known to limit market falls for a long time among investors.
