Dividends are corporate profits distributed to shareholders. Dividend payment factors include company profitability, capital needs, stock price trends and investor expectations. A company must act in the best interest of its shareholders, so in making dividend decisions it considers the impact on the company business, the share price and shareholder value.
The single biggest dividend payment factor is profitability: a company must be profitable to be able to pay dividends. The more profit a company generates, the more it can afford to pay out in dividends. If a company is experiencing financial difficulties, such as falling sales or soaring costs that lead to losses, it simply can’t afford to pay dividends. Mounting losses can jeopardize a company’s very existence. To survive, the company may cut the dividend to conserve cash.
A company can use corporate profits in a variety of ways: reinvest profits back into the business to grow or expand, acquire another business or buy back its own stock to boost the stock price. Addressing all those needs is a balancing act whose outcome often determines how much of the profit to pay out in dividends and how much to retain for other corporate needs.
Companies know their investor bases – the shareholders who own the stock for specific reasons. Conservative, income-oriented investors buy stocks that pay generous dividends and increase them over time. Companies try to maintain predictable dividend policies to keep shareholders happy because stock selling by disgruntled shareholders may send the stock price down. In a bad quarter, some companies may even defer operating expenses or borrow money to maintain the dividend at the current level.
A company must make sure the dividend is sufficient to keep investors happy, but not too excessive, so that it can continue to pay it the future. The ratio of current profits to current dividend is called the dividend coverage; the ratio of current dividends to current profits is called the dividend payout ratio.
Enhancing Shareholder Value
A dividend increase can cause a stock price to go up by making it more valuable to investors, who are willing to pay more for it. A dividend decrease can cause a stock price to go down because the stock becomes less valuable to investors, or because the decrease is a sign of falling profits or other financial difficulties. A dividend increase often affects a stock price more than the actual dividend amount. Cognizant of that, a company may pay small dividends but increase them periodically to boost the stock price.