Understanding the Dividend

How Dividend Provides Early Signal About Selection of Stocks

 

Dividend

A dividend is a share of a company's profits distributed to shareholders as a part-owner of the company. After earning profits management can choose an option to retain it or distribute a portion of profits as dividends to its shareholders.

 

Although, dividends are not guaranteed and depend upon the discretion of the board of directors. A young company needs to reinvest all its capital to fuel growth and may decide not to declare any dividend. But when the growth slows and further expansion is limited, declaration of dividends will be necessary to keep shareholders around.

 

Declaration of Residual Profits as Dividends

Declaration of residual profits to its shareholders as dividends is a visible sign of the financial health of the company. It also signals that the growth of the company has slowdown and the time have come to reward its shareholders. The management who is sitting at the driver's seat knows better the financial prospects of the company. Therefore, stable or rising dividend from the previous year's indicates a lot of financial health about the company.

 

A company's dividend declaration to its shareholders is a device that investors can use as a signal about the prospects of the company. Apart from financial ratios, clear scrutiny of historical dividends provides a lot of information about the prospects of the company.

 

Steady and Gradual Increase in Dividend Payment

When a company has less room to grow and earnings profits, management is willing to reward their shareholders and continue to pay handsome dividends. The trend likely to continue for years if everything goes smoothly. Holding such types of stocks is good in a portfolio because not only do they provide risk-free income but price appreciation is also there.

 

When management declares a dividend, they know better those investors are watching their policy closely. Fluctuations in dividends give any positive or negative signals in the market unnecessarily. Therefore, a steady and gradual increase in dividend payment is a healthy sign and most of the companies adopt this policy.   

      

Rapid growth companies unlikely to offer dividends but the growth must be visible while looking at its sales.

 

A Sudden Cut in Dividend

In case of any negative signal about the prospects, the likely action of the management to save all cash outflow. Therefore, a sudden cut in dividends is a clear indication that the company likely to face a shortage of cash or other challenges in near future. A company may skip paying a dividend if they plan for any reinvestment or to cover costs.

Therefore, an investor should have an open eye on all the developments and it is good to avoid such kind of stock for the time being. If you want to go ahead then you must have sound logic behind the sudden cut or skip in paying a dividend. Such type of action indicates that an investor has to do further scrutiny of the stock and cannot take it lightly.

 

When an established company which is paying dividend at a regular interval, suddenly increases, decreases or skip in paying, an investor must have to examine all the scenarios.

 

Because dividends provide a signal about the financial health of the company, I have seen in my experience that most of the companies hesitate to reduce what they have already declared in the previous year. Even after facing problems from many fronts, the company does not want to give any negative signal in the market, therefore, they continue with their stable dividend policy.

 

However, every reduction in dividend does not give a negative signal about the company, neither increase provides a positive signal. There are times when a company continues to pay a stable dividend and not able to increase even for years.

 

Dividend Yield Strategy

The theory of “Dogs of the Dow” says that select 10 stocks with the highest dividend yields from the Dow Jones Industrial Average. However, I have seen in my experience that those stocks where dividend yield is more than 10% are not good enough to include in a portfolio. Large-cap stocks, where dividend yield is more than the yield of Nifty and dividend is stable or rising, are good to include in a portfolio. For midcap stocks, where yield is more than 3% is good to consider if others parameters are supporting.

 

The Bottom Line

The dividend provides a lot of valuable information about the company. A study of historical dividends provides a clear signal about the financial health of the company. When a company suddenly cut the dividend, the time has come to examine all the developments as it may signal a problem is coming in near future.   

 

A company can't keep growing forever, ups and downs are part of the business. Dividends provide a lot of valuable information about the company. While analyzing a stock it simply can't be ignored.  

 

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