Recent Dividend Cuts

For many investors, the object of investing in dividend-paying stocks is to either pocket or re-invest the regular dividends they receive as a reward for their owning the company’s stock. Dividend stocks are typically not growth stocks and while they may not have the downside volatility that growth stocks have, they also do not present as large of an upside return in share price.

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 the dividend. In fact, a select group of companies are Dividend Aristocrats, which means they 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 payment for over 50 years.

Therefore, when a company cuts or suspends its dividend it is seen as a sign of financial weakness that has a material effect on the wealth of shareholders. In the great recession, nearly $100 billion in dividend income was lost in 2008 and 2009.

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.

Introduction

A dividend cut is an event that a company takes when, for a variety of reasons, it decides to reduce the amount of money it pays out to shareholders as a dividend. In a worst-case scenario, a company may decide to stop paying out dividends entirely (i.e. suspends its dividend). Either of these scenarios will have a negative effect on the company’s stock.

Dividends are paid out of a company’s earnings. So a dividend cut is evidence that a company either does not have, or is not forecasting that it will have, enough revenue to maintain its dividend at its current level.

In this article, we provide an overview of why dividends are important, how they are calculated and how they impact a stock’s total return. With that as a background, we’ll go into some detail about why a company may cut its dividend. We’ll also give you some idea of what signals investors may get that lets them know that a company is getting ready to cut its dividend. We’ll also go over the effect it may have on a company’s stock price and why sometimes the stock price can reverse course quickly.

Why are dividends important?

Before describing why a company would cut its dividend, let’s take a moment to remember why dividends are issued in the first place. A dividend is a portion of a company’s profits (or earnings) expressed as a percentage.

A company typically issues a dividend as a way of rewarding its shareholders for their investment. And why would they do this? After a company pays their short-term liabilities, they can either allocate a share of their profit to reinvest into the business or to give back to shareholders.

Companies can choose to pay dividends quarterly, semi-annually or annually.

However, 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.

How are dividends calculated?

Just as a company is under no obligation to issue a dividend, it is not obligated to calculate its dividend in a specific way. The amount of a company’s dividend is typically calculated using either a net income or a free cash flow model.

There are a couple of notable exceptions to this statement. 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. For capital intensive companies, free cash flow is a more important measurement than net income in determining their dividend payout.

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 paid out $2.50 per year in dividends with a stock price of $50 has a dividend yield of 5%.

Dividend yield, however, can be a little bit of a deceptive metric. Some investors mistakenly invest in stocks with the highest dividend yield. But since the dividend yield can be affected by the stock price, if the stock rises or falls, the dividend yield can change dramatically. If the stock price rises, the yield will go down. If the stock price falls, the yield will go up.

In our earlier example, if the $50 stock increased to $55, the yield would fall to 4.54%. Conversely, if the stock price fell to $45, the yield would increase to 5.56%.

A dividend impacts an investor’s total return

The significance of a dividend is reflected in a stock’s total return. This is an investor’s gain or loss on a 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%.

When an investor is buying a growth stock (e.g. most big tech stocks), they aren’t expecting to be paid a dividend. These companies are typically on the leading edge of their sectors, they are constantly reinvesting for the purpose of growing their business. These companies reward their shareholders with profits that grow quickly and a higher share price. In general, growth stocks tend to be volatile which means they are only appropriate for investors with a higher risk tolerance.

On the other hand, if an investor is buying a blue-chip stock, they are looking for value. And a dividend provides value. The same is true of income stocks such as REITs and utility stocks.

Why do companies cut their dividends?

In most cases, a company will cut its dividend because of some underlying financial weakness. This may be due to slumping profits which may be due to declining revenue or narrower margins. When earnings decline, a company needs to increase its payout rate or access capital from other sources (e.g. short-term investments or debt) to sustain its dividend.

However, this can put the company in a dangerous position. By prioritizing its dividend the company could wind up lacking cash to pay its short-term debt obligations. That would lead to a default, which is why the vast majority of companies would rather slash or suspend its dividend when faced with declining earnings.

However, while this is a responsible course of action, many investors will perceive it as a negative. This is simply because a company is acknowledging that they are not likely to have enough money available to pay out the same dividend that they had in the past.

There are times when a company cuts their dividend for other reasons than financial weakness. For example, stock buybacks have come back into favor. And many companies use this as a way to boost their share price. Here’s how it benefits shareholders. When a company buys back shares from the market the number of outstanding shares shrinks. The effect of having fewer shares available for investors to purchase is that each individual shareholder’s shares have more value.  

What are the signs that a company is about to cut its dividend?

Investors can calculate a company’s payout ratio to test how secure its 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 above 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 that the company is in 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 that would be 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.

What did dividend cuts look like during the great recession?

As mentioned above one of the times when a company is most likely to cut its dividend is during a recession. This was illustrated in a big way at the onset of “the great recession” in 2008 and 2009. In 2008, 61 companies cut their dividends resulting in $40.6 billion in lost dividend income.

However, just a few months into 2009, an additional 41 companies cut their dividend payouts resulting in an additional $40.8 billion in lost income for shareholders. By the time 2009 came to a close that number would rise to $52.6 billion.

What happens to a stock’s performance when it cuts its dividend?

In virtually all cases, a stock will decline in value when a company cuts its dividend. That’s because, whether the dividend was cut for valid reasons or not, 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 being insignificant, the stock may quickly rise. A good example of this occurred at the onset of the coronavirus pandemic. Entire sectors such as hospitality, airlines, and automotive were   shut down. In an effort to conserve cash many of these companies either suspended their dividend or cut it dramatically.

At first, these stocks plummeted. However, as more news became available, not to mention the government’s stimulus effort, it became apparent that many of these companies would receive money to keep them afloat and stock prices began to rise.

A dividend cut however has the effect of decreasing the wealth of shareholders because of the loss of dividend income. For many investors, seeing a share price go down is a loss of wealth that they can make up, given enough time. However, when a shareholder loses dividend income it has a more lasting effect. That’s money that they won’t get back. For many investors that may sour them on a stock forever.

The final word on dividend cuts/decreases

Dividends are a measure of a company’s financial stability. That’s why a dividend cut or outright suspension of a dividend 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.