The dividend helps to boost the stock’s total return which, particularly in down markets, can help make owning these stocks more profitable than owning growth stocks. Many dividend-paying companies have solid balance sheets that allow them to weather tough financial conditions without having to cut their dividend, but not all.
There is a select group of companies called Dividend Aristocrats which means they are S&P 500 (NYSEARCA: SPY)companies that have increased their dividend payment for 25 consecutive years. And an even smaller group of companies are Dividend Kings which means they have increased their dividend payments for over 50 years. These companies are assumed to be financially strong and come with very low risk.
Therefore, when a company cuts or suspends its dividend it is seen as a sign of financial weakness and that has a material effect on the wealth of shareholders. When dividends get cut stock prices fall. In the great recession, nearly $100 billion in dividend income was lost in 2008 and 2009 and that drove the stock market down by 50%.
However, while a dividend cut is generally due to severe financial pressure, there are occasions when a company cuts its dividend for less odious reasons. It’s always up to an investor to perform their due diligence when understanding the reason for a dividend cut.
Dividend Cuts Improve Cash Flow And The Balance Sheet
A dividend cut is a serious event that a company takes as a last-step resort to curb cash bleed and shore up balance sheets. When an S&P 500 company decides to reduce the amount of money it pays to shareholders as a dividend it has a far-reaching repercussion that can leave slow-moving investors with very large losses. In a worst-case scenario, a company may decide to stop paying out dividends entirely (i.e. suspend its dividend) which will have an even worse impact on share prices.
Dividends are paid out of a company’s earnings, so long as earnings are good the dividend should be consistent but there are other factors like debt, too. In one way, a dividend cut is evidence that a company does not have, or is not forecasting that it will have, enough revenue, earnings, cash flow, or cash on hand to maintain its dividend at its current level without some change to the fundamentals.
Why Are Dividends Important, Cash Flow!
A dividend is a portion of a company’s profits (or earnings) expressed as a percentage of its price. Assuming the dividend amount remains constant, the yield goes up when the stock price falls and goes down when the stock price rise.
A company issues a dividend as a way of rewarding its shareholders for their investment. After a company pays its short-term liabilities, it can either allocate a share of its profit to reinvest into the business or to give back to shareholders. In the best cases, a company can pay a dividend, buy back shares, and self-fund growth initiatives while paying down and servicing debt too.
- Companies can choose to pay dividends quarterly, semi-annually, or annually.
It’s important to note that a company is not under any obligation to offer a dividend, nor does the issuing of a dividend legally obligate them to retain or sustain that dividend. The decision to pay a dividend is voted on by a company’s board of directors.
Just as a company is under no obligation to issue a dividend, it is not obligated to calculate its dividend in a specific way unless there is a managed distribution plan. An MDP could result in a fluctuating payment so be sure to check on that when doing your research. Otherwise, the company pays what it pays.
There are a couple of other notable exceptions to this statement though. Real estate investment trusts (REITs) and master limited partnerships (MLPs) are legally required to pay a majority (at least 90%) of their cash flow as dividends. When cash flow is down the dividend is down.
For investors, a company’s dividend is expressed as a percentage known as the dividend yield. A dividend yield is the annual amount of a company’s dividend divided by the current stock price. For example, a company that pays out $2.50 per year in dividends with a stock price of $50 has a dividend yield of 5%.
How A Dividend Impacts The Total Return
The significance of a dividend is reflected in a stock’s total return. This is an investor’s gain or loss on stock plus the amount of any dividend. Here’s an example:
An investor buys 100 shares of stock in company X for $50 and the stock rises in value by $5 for the next 12 months. At the end of that period of time, the investment’s total return is 10% or $500 ($5 x 100 = 500). The investment is now worth $5,500.
Another investor buys 100 shares of stock in company Y for $40. That stock increases in value by $4 over the next 12 months. However, the stock also paid $1.20 per year. That means the stock’s total return was $5.20 per share or 13%.
Why Do Companies Cut Their Dividends?
In most cases, a company will cut its dividend because of underlying financial weakness. This may be due to declining revenue, slumping profits, or unmanageable debt. When cash flow declines, a company needs to increase its earnings or access capital from other sources (e.g. short-term investments or debt) to sustain its dividend and that is not always possible.
Prioritizing its dividend could leave the company unable to pay its short-term debt obligations. That could lead to a default which is why the vast majority of companies would rather slash or suspend its dividend.
While this is a responsible course of action, many investors perceive it as a negative for the company’s value and it usually is. This is simply because a company is acknowledging a weakened financial position and inability to pay out the same dividend.
There are times when a company cuts its dividend for other reasons than financial weakness, however. For example, stock buybacks have come back into favor and may take the place of dividends. Here’s how it benefits shareholders. When a company buys back shares from the market the number of outstanding shares shrinks and makes each one more valuable relative to the whole company.
Which Companies Will Cut Their Dividends?
Investors can calculate a company’s payout ratio as a gauge of how safe a dividend may be. For a company to sustain its dividend, it has to have enough net income to support making that payment. If a company pays out 50 cents per share in dividends each quarter and has net earnings per share for that quarter of $2, the payout ratio is 25% (50/2 = 0.25).
Generally speaking, the lower the payout ratio the more secure the dividend. However, as pointed out, REITs and MLPs have legal requirements that require a high payout ratio.
If a company’s payout ratio increases significantly, particularly compared to other companies in its sector, that may be a sign the company is under financial duress.
There are other circumstantial signs that a company may be about to cut its dividend. For example, if the broader economic outlook becomes weaker, that could be a sign that a company affected by recessions might have to cut its dividend in an effort to conserve cash.
A company may also be looking to grow through acquisition. If this is the case, a company may look to reduce or suspend its dividend temporarily to ensure it has enough cash to make the purchase.
When Dividends Are Cut Stock Prices Fall
In virtually all cases, a stock will decline in value when a company cuts its dividend. That’s because the investing community perceives that the company is going through financial challenges. The resulting uncertainty will lower the value of the stock, at least in the short term.
If the reason for the dividend cut is later seen as insignificant, the stock may quickly rise but don’t count on that happening. A good example of this occurred at the onset of the coronavirus pandemic. Entire sectors were shut down so, in an effort to conserve cash, many of these companies suspended their dividend or cut it dramatically but then later reinstated them.
Dividend Cuts, Beware The Dangers
Dividends are a measure of a company’s financial stability. That’s why a dividend cut or suspension is so devastating to a company’s reputation. There are times, particularly during “Black Swan” events such as 9/11 when investors understand that a dividend cut is not a sign of fundamental problems within a company. And in these cases, it may not be in a shareholder’s best interest to sell the stock. In fact, selling the stock may do more harm to their portfolio than the loss of dividend income. Like all investment decisions, it’s up to individual investors to decide what a dividend cut means for their portfolio.
