One of the simplest ways for companies to communicate financial well-being and shareholder value is to say "the dividend check is in the mail." Dividends, those cash distributions that many companies pay out regularly to shareholders from earnings, send a clear, powerful message about future prospects and performance. 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 Before corporations were required by law to disclose financial information in the 1930s, a company's ability to pay dividends was one of the few signs of its financial health. Despite the Securities and Exchange Act of 1934 and the increased transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company's prospects.
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" company 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 progression of Microsoft through its life cycle demonstrates the relationship between dividends and growth. When Bill Gates' brainchild was a high-flying growth company, it paid no dividends, but reinvested all earnings to fuel further growth. Eventually, this 800-pound software "gorilla" reached a point where it could no longer grow at the unprecedented rate it had maintained for so long. So, instead of rewarding shareholders through capital appreciation, the company began to use dividends and share buybacks as a way of keeping investors interested. The plan was announced in July 2004, nearly 18 years after the company's IPO. The cash distribution plan put nearly $75 billion worth of value into the pockets of investors through a new 8 cent quarterly dividend, a special $3 one-time dividend, and a $30 billion share buyback program spanning four years. In 2010, the company is still paying dividends of 1.8%
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 (think Microsoft).
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.
The Dreaded Dividend Cut
If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming.
While a history of steady or increasing dividends is certainly reassuring, investors need to be wary of companies that rely on borrowings to finance those payments. Again, take the utilities industry, which once attracted investors with reliable earnings and fat dividends. As some of those companies were diverting cash into expansion opportunities while trying to maintain dividend levels, they had to take on greater debt levels. Watch out for companies with debt-to-equity ratios greater than 60%. Higher debt levels often lead to pressure from Wall Street as well as debt-rating agencies. That, in turn, can hamper a company's ability to pay its dividend.
Dividends bring more discipline to management's investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets. Studies show that the more cash a company keeps, the more likely it is that it will overpay for acquisitions and, in turn, damage shareholder value. In fact, companies that pay dividends tend to be more efficient in their use of capital than similar companies that do not pay dividends. Furthermore, companies that pay dividends are less likely to be cooking the books. Let's face it, managers can be awfully creative when it comes to making earnings look good. But with dividend obligations to meet twice a year, manipulation becomes that much more challenging.
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.
A Way to Calculate Value
Dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share, and it is a staple of the capital asset pricing model which, in turn, is the basis of corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, 'discounted back' to their net present value. As dividends are a form of cash flow to the investor, they are an important reflection of a company's value.
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.
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