Investment Education: Dividend Increases or Decreases can Signal Management’s Expectations.

Sep 18, 2014 Investment Education: Dividend Increases or Decreases can Signal Management’s Expectations.

When a company raises or lowers its dividend, it is intentionally or unintentionally sending a message to investors. A dividend increase generally is telling investors that management is confident that current earnings and cash flow are expected to be adequate to maintain the higher dividend level in the future. (Companies like to avoid having to cut their dividend as it send a negative message to investors, implying that earnings growth may be slowing, or there is some problem at the company.)

Because this signaling is inherent in the declaring of dividends, it is useful for investors to anticipate whether a company might raise or reduce its dividend, or leave it unchanged from the prior quarter. After the dividend is declared, investors will see how it compared to expectations, and see how the stock price reacts.

Let’s look at a company that has a long history of raising the dividend in the second quarter.

If the company does not increase its dividend in the next second quarter, investors may assume, rightly or wrongly, that management is not confident that it’s earnings and cash flow will be adequate to meet upcoming needs. This could be because management foresees an earnings decline, leaving cash flow unable to both fund operations and pay an increased dividend. A more benign reason for not increasing the dividend would be that although earnings growth is strong, the company has an unusually large capital spending program underway, or has a large debt repayment, or has some other large cash need, such as paying for a large acquisition. In this case the disappointing dividend declaration would be less likely to hurt the stock. Similarly, if the dividend was not increased because the company is initiating, or increasing, a stock buy back program, investors might view this positively and push the stock higher.

Let’s assume the dividend is raised in the second quarter. Now investors will look at how much the increase was compared to prior years increases. If the percentage increase in the dividend is more or less than in prior years, that may also send a signal that management is more or less optimistic about the future.

As investors, we can develop a reasonable expectation of the likelihood and amount of a dividend increase, and therefore be ready to act if the dividend is outside our band of expectations. Here is what I do. First I look at the company’s historic dividend payout ratio. The dividend payout ratio is simply the dividend per share the company pays in a given year, divided by the earnings per share for the same year. If a company has a history of paying out between 50-60% of its earnings as a dividend over a period of years, it is a good starting place to assume the payout ratio will remain in or near that band. Then, multiply the 50% and 60 % figures by your earnings estimates for this year and next. Most of us of course do not have our own earnings estimates, but as we discussed in our Investment Education blogpost of July 24, 2014, (found on our website at: www.whystocksgoupanddown.com) earnings forecasts can be found on the internet through both a Google search and using brokerage firm website research tabs. After establishing a likely band for dividends for this year and next, I then make a check list of pluses and minuses of factors that could impact the company’s dividend decision. Examples: PLUS: interest rates are expected to remain low, so the company can borrow easily if it needs cash for unusual spending needs. PLUS: a recent run up in the stock price has caused the yield on the stock (the dividend divided by price of the stock ) to decline relative to other dividend paying stocks. By raising the dividend, the stock’s yield at the current price goes back up, making the stock more attractive again. MINUS: the company announced that they are looking at large acquisitions. Companies attempting to make large acquisitions often postpone dividend increases until they know how much money they will need for the acquisition. Also, many companies have postponed dividend increases while digesting expensive acquisitions. MINUS: taxation of dividends has increased, so because stockholders will get to keep less of the cash dividend they receive, companies might decide it is more beneficial for their shareholders if they use the money to buy back outstanding stock rather than pay dividends.

As the board of directors weighs the plusses and minuses while deciding what dividend to pay, so also will investors be developing expectations for the company’s dividend decision, and thus they will be better prepared to interpret the dividend announcement.

As part of your investment education, I encourage you to choose a few companies that are regular dividend payers, and follow their earnings, cash flow, and dividends over time, and watch the stocks’ performance both before and after dividend announcements.