"Seeing my dividend arrive is the only thing that makes me happy, "Rockefeller, John D.
The phrase "the dividend cheque is in the mail" is among the simplest methods for businesses to convey their financial health and shareholder value.
Dividends are those cash transfers from earnings that many businesses make frequently to owners and that provide a strong, clear statement about future prospects and performance.
Good indicators of a company's fundamentals include its willingness, capacity, and ability to pay consistent dividends over time—as well as its capacity to grow them.
Important
● >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 higher yield is more appealing, while a lower yield can make a stock appear less competitive in relation to its industry. The dividend yield calculates how much income 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 between earnings and the net dividend shareholders receive.
● >Businesses 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.
Fundamentals Signal Dividends
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 indicator of a company's prospects notwithstanding the Securities and Exchange Act of 1934 and the greater 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.
Nonetheless, 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 shareholders through capital appreciation. In July 2004, about 18 years after the company's IPO, the plan was revealed.
With a new 8-cent quarterly dividend, a special $3 one-time pay-out, 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 business will still be paying dividends in 2022.
The Yield of Dividends
The dividend yield, which is determined by dividing the annual dividend income per share by the stock's current share price, is a popular measurement among investors. The amount of income received in relation to the share price is measured by the dividend yield.
When a company's dividend yield is low compared to other companies in its industry, one of two things may be true: either the stock price is high because the market believes the company has promising future prospects and is not overly concerned about the company's dividend payments, or the company is in financial trouble and cannot afford to pay reasonable dividends.
Nevertheless, a corporation with a high dividend yield 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, the dividend yield is of little significance when assessing growth businesses. Instead, owners will profit in the form of capital gains (think Microsoft).
Important
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 can afford to pay the dividend when assessing its dividend-paying policies. Dividend coverage, a ratio between a company's earnings and the net dividend paid to shareholders, is still a popular way to assess if earnings are high enough to meet dividend obligations.
Earnings per share divided by dividends per share is how the ratio is computed. There is a significant chance that there will be a dividend cut when coverage is thin, which might have a disastrous effect on value.
A coverage 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 pay-outs, managers are indicating to investors that they anticipate solid business conditions for the next year or more.
The Agonizing Dividend Cut
Investors may consider it a warning sign if a company that has a history of steadily increasing dividend payments abruptly reduces its pay-outs.
While a track record of consistent or rising dividends is undoubtedly comforting, investors should be mindful of businesses that rely on borrowing to make those payments.
Consider the utilities sector as an example, which formerly lured investors with steady earnings and high dividends. Several of those businesses had to incur more debt since they had to use cash from expansion prospects to keep up dividend levels.
Beware of businesses with debt-to-equity ratios higher than 60%. Increased debt levels frequently result in pressure 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, the more cash a corporation retains, the more likely it is to overpay for acquisitions and hence reduce shareholder value. In actuality, businesses that pay dividends typically employ capital more effectively than comparable businesses that don't. Companies that pay 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. Yet 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.
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 dividend payments, "discounted back" to their net present value, in accordance with the model. Dividends are an essential indicator of a company's worth because they represent a type of cash flow to the investor.
In a nutshell
It's vital to remember that stocks with dividends have a lower likelihood of rising to unsustainable levels. Dividends have long been known to limit market declines among investors.
