Profitable companies have several ways to attract investors. Share buybacks or stock splits can make stock ownership attractive. Year-over-year revenue growth is another reason for investors to buy shares. For some solid, mature companies, offering dividends is a great way to show investors that the company is strong. Well, how do dividend distributions affect what investors see about your company?
A dividend is paid out on a regular basis from corporate earnings. Providing dividends to shareholders sends a powerful message that earnings are high enough and operations are efficient enough to offer some regular income to stockholders. If dividends are disbursed consistently – and if they increase – it provides a clue that fundamentals are strong. Even with today’s SEC-mandated transparency, a dividend is the only clear sign that times are good for the company.
High growth companies won’t typically provide dividends because much of the growing earnings are plowed back to generate further growth. Those companies reward shareholders with rising stock prices. For mature investors facing retirement, dividends are a more attractive option because they are usually consistent in nature.
Dividend payouts should come from cash reserves. A company that gives shareholders money from its operating budget is on a slippery slope to failure. So a dividend should tell ownership that financial health is good.
The dividend yield expresses how well per share income relates to the stock price, so if dividends have been consistent or rising, the stock price should rise as well. This makes shareholders happy as they see their capital gains increase without purchasing more stock. Yields vary by industry so value investors will look to see if your company’s yield is in line with direct competitors. A low dividend yield could signal that a) the stock price is high, which could mean a positive outlook for future earnings or b) that the company is struggling to pay out of earnings (which could spell doom!).
On the other hand, if your dividend yield is high, this could mean that speculation about the company is negative. There may be signals that the horizon is not sunny because the stock price has become depressed.
Dividend Coverage Ratio
Another indicator that stock analysts use is the dividend coverage ratio, which measures earnings per share (EPS) divided by dividends per share (DPS). This metric will show investors how well earnings are “covering” dividend payouts. If the ratio becomes narrow, for example EPS at $3.00 and DPS at $2.75, it could mean there is not enough financial strength to continue paying the dividend amount routinely. That could lead to a dividend cut.
Dividend cuts are a sure sign that business is not as rosy as it has been. If your company declares a lower dividend, investors might look at other opportunities; however, some companies cut dividends in order to put cash into an acquisition or new market opportunity. Analysts will look at what the diverted funds will be used for before cautioning investors, but shareholders seeking income may still be wary of future issues.
One last point: If a company has to borrow to fund dividend payouts for more than one dividend period – usually one fiscal quarter – there may be trouble ahead. Most analysts agree that raising the debt level is worrisome, especially if the debt is used to pay shareholders. At times, utilities may borrow for expansion efforts while still paying dividends, but over the long haul, additional debt should not be used for the purposes of maintaining income payouts.
Choosing to offer dividends is a great way to foster investor confidence and attract institutional investment. But managing dividend payouts is critical to maintaining your company’s financial health.