Dividends offer a way for companies to communicate their financial health and shareholder value. Dividends are those cash payments that many companies pay regularly from their earnings to the stockholders.
At the same time, investors value dividends for many big reasons, which we will list below. Check them out!
Communicates the Company’s Fundamentals
Before companies were required by law to disclose financial information in the 1930s, the company’s ability to pay dividends was one of the few indicators of its financial health. And even after the SEC Act of 1934 and the better transparency, dividends still remain a worthwhile yardstick of a company’s prospect.
Often, mature and profitable companies pay dividends. But of course, when a company doesn’t pay dividends, it doesn’t mean it’s without profits.
If the company believes that its own growth opportunities are better than investment opportunities available to stockholders everywhere, if usually keeps the profits and reinvests them into the corporation.
Many investors prefer to monitor the dividend yield, which is calculated by dividing dividend income per share by the current share price. Other words, this metric measures the amount of income received in proportion to the share price.
If a company has a low dividend yield compared to other companies within the same sector, it often means two things.
First, the stock’s share price is high because the market believes the company has impressive prospects and isn’t too worried about the company’s dividend payments. The second one is that the company is in trouble and cannot afford to pay dividends. The company with high dividend yield may be signaling its problems and has a decreased share price.
Dividend Coverage Ratio
When analyzing the company’s dividend practices, take note whether the company can afford to pay the dividend.
The ratio between the company’s earnings and the net dividend paid to shareholders, or the dividend coverage, is also a useful tool for gauging whether earnings are enough to cover the dividend obligations.
The ratio is calculated by dividing the earnings per share by the dividend per share.
When the coverage gets thin, chances are that there will be a dividend cut. Such a move can have adverse effects on valuation.
If the company has a history of consistently increasing dividends suddenly slashes its payments, investors should consider that as a sign that trouble is coming.
Although a history of consistent and regular dividend is welcome, investors also need to see whether the company relies on debt to finance the dividend obligations.
Be wary of companies with high debt-to-equity ratios (higher than 60%). Higher debt levels usually result in higher pressure from Wall Street and debt-rating agencies. This, as a result, can hinder a company’s ability to pay dividends.
Bringing more Discipline
Dividends bring more discipline to the management’s investment decision-making. Holding on to the profits may result in excessive executive compensation. It may also lead to sloppy management and inefficient use of assets.
According to studies, companies that keep more are more likely to overpay for acquisitions and thus damage shareholder value.
Overall, studies suggest that companies who pay dividends are more efficient in their use of capital than similar companies that do not pay dividends.
Capital Pro provides digital classes headed by expert and professional analysts with the goal of spreading useful insights about the investing world. Capital Pro Goal is to provide Financial Education.