What is a Dividend?
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders.
When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.
A company’s willingness and ability to pay steady dividends over time – and its power to increase them – provide good clues about its fundamentals.
Dividends Signal Fundamentals
Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the profits and reinvest them into the business. For these reasons, few “growth” companies pay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and handle contingencies.
The Dividend Yield
Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things:
(1) the share price is high because the market reckons the company has impressive prospects and isn’t overly worried about the company’s dividend payments, or
(2) the company is in trouble and cannot afford to pay reasonable dividends. At the same time, however, a high dividend yield can signal a sick company with a depressed share price.
Dividend yield is of little importance for growth companies because, as we discussed above, retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains .
Dividend Coverage Ratio
When you evaluate a company’s dividend-paying practices, ask yourself if the company can afford to pay the dividend. The ratio between a company’s earnings and net dividend paid to shareholders – known as dividend coverage – remains a well-used tool for measuring whether earnings are sufficient to cover dividend obligations. The ratio is calculated as earnings per share divided by the dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut, which can have a dire impact on valuation. Investors can feel safe with a coverage ratio of 2 or 3. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under 1, the company is using its retained earnings from last year to pay this year’s dividend.
At the same time, if the payout gets very high, say above 5, investors should ask whether management is withholding excess earnings, not paying enough cash to shareholders. Managers who raise their dividends are telling investors that the course of business over the coming 12 months or more will be stable.
Finally, dividends are public promises. Breaking them is both embarrassing to management and damaging to share prices. To tarry over raising dividends, never mind suspending them, is seen as a confession of failure.
It is important to note also that stocks with dividends are less likely to reach unsustainable values. Investors have long known that dividends put a ceiling on market declines.
Conclusion
The bottom line is that dividends matter. Evidence of profitability in the form of a dividend check can help investors sleep easily. Profits on paper say one thing about a company’s prospects; profits that produce cash dividends say another thing entirely.