Dividends are a distribution of a company’s earnings, or profits, to shareholders. A company is not obligated to pay dividends and can choose whether to increase or decrease its dividends, or leave them unchanged. A company considers many factors when making decisions about its dividend payments and can increase the payments for various reasons. Understanding some of these reasons can help you determine if a company is using its capital effectively.
A profitable company that builds up excess cash looks for the best ways to use it, such as investing in new equipment or acquiring other companies. If a company has limited investment options that offer low potential returns, a dividend increase may be its best alternative. This reason for an increase typically occurs in mature companies that are well established and have little room for growth, but occurs less frequently in companies that are experiencing high growth and that are reinvesting their earnings for expansion.
Following Dividend Policy
A company’s previous management and directors may have implemented a dividend policy many years ago that calls for consistent increases in dividends. The company’s current management may increase dividends based on that established policy to avoid a possible decline in stock price. If a company has a history of consistently increasing its dividends, shareholders expect the increases to continue. If the company were to leave its dividend unchanged or decrease it, shareholders may sell the stock, which would decrease its price.
Investors sometimes see an increasing dividend as a sign of a company’s confidence in its future earning potential. A company may increase its dividend to demonstrate this confidence to investors, which may entice them to increase its stock price. A company’s plan may backfire, though, if investors believe the company should use its capital for other purposes. For example, if a company is in financial trouble and increases its dividend when it should be using its money for debt payments, investors may bid down its stock price.
Attract New Investors
A company may increase its dividend to attract new investors to its stock. For example, some investors, such as certain pension funds, may only buy stocks that pay a certain level of dividends. These investors may consider investing in a company if it increases its dividend to meet their requirements. A higher dividend may also create a larger base of longer-term investors, which could help maintain a more stable stock price with fewer fluctuations.
- PrinciplesofAccounting.com: Chapter 14 -- Corporate Equity Accounting
- New York University, Stern School of Business: Dividend Policy
- Contemporary Financial Management, 11th Edition; R. Charles Moyer et al.