Friday, June 24, 2022 by DividendStocks.com Staff
The primary benefit of a dividend is the opportunity for investors to collect regular income. They can use their dividend payments as a source of extra income to meet their expenses. Or, in many cases, investors who don’t need the income from their dividends right away can reinvest their dividends to buy more shares of that particular equity. When they do, they benefit from the compounding effect.
With that in mind, it’s easy to understand why investors pay close attention to the amount of the divided (i.e. the dividend payout). At the very least, investors want to see a dividend payout that stays consistent over time. So when a company cuts its dividend it’s almost always a cause for concern.
Dividend cuts signal that a company is going through a period of financial difficulty. In this article, we’ll review why companies issue dividend cuts and why it’s always a signal for investors to proceed with caution before continuing to invest in that stock.
Why Does a Company Issue a Dividend Cut?
When a company issues a dividend cut it does so primarily for one of two reasons:
- Declining earnings or increased debts – Although this should be concerning for investors, it may only reflect short-term economic conditions.
- Reinvesting in the business - Sometimes a company will cut its dividend payment as part of a longer term strategy such as to prepare its balance sheet to absorb an acquisition or to buy back shares of its stock. Repurchasing shares is another way that companies attempt to build shareholder value.
A dividend is almost always paid from a company’s earnings (i.e. profit). The amount of the company’s dividend relative to its total earnings is called the payout ratio. Many companies that have a long track record of issuing dividends have stable, mature businesses with strong balance sheets. This makes their dividend sustainable even if they have a quarter or two of declining earnings. This is because the company has the flexibility to access capital from other sources to maintain its dividend level.
However, for other businesses, weaker earnings mean they have to reallocate money to shore up their balance sheet. That’s because if these companies try to access capital from anywhere other than earnings they can find themselves in a precarious financial position. In this case, a dividend cut may be the least bad option. And that’s a reason why it’s normally at the top of the list when it comes to actions a company will take when they face financial difficulties.
Is a Dividend Cut Always a Sell Signal?
If an investor needs the income from the dividend to meet current expenses, then a dividend cut is almost always a signal to sell. However, for investors who have a longer time horizon, it’s important to understand the exact reason for the dividend cut.
For example, sometimes the dividend cut is based on short-term macroeconomic conditions that are largely outside of the company’s control. For example, at the onset of the Covid-19 pandemic many companies particularly companies such as cruise lines and airlines issued dividend cuts in anticipation of historic demand destruction.
What is a Dividend Suspension?
Another action a company may take is to suspend its dividend altogether. This is a more drastic measure than a dividend cut because it means that instead of reducing the amount of its payout it will not be paying any dividend at all.
Dividend Yield vs. Dividend Payout
Dividend payout is the dollar amount per share that a company will pay shareholders on the payment date. Seeing this number remain stable or better yet increase should give investors more confidence that the company is on strong financial footing.
This is different from the dividend yield which is not a reliable indicator of how much money an investor will get from owning a dividend stock.
Understanding the Payout Ratio
The dividend payout lets you calculate a company’s payout ratio. The formula for calculating the company’s payout ratio is dividends paid divided by net income.
Company’s normally calculate several different payout ratios. Some of the most common include:
- Payout ratio based on trailing 12 months (TTM) of earnings
- Payout ratio based on the current year’s earnings estimates
- Payout ratio based on next year’s earnings estimates
- Payout ratio based on cash flow
The Last Word on Dividend Cuts
Dividends are one way that a company uses to build shareholder equity. In most cases, once a company begins to issue a dividend they will make every effort to sustain the dividend. A dividend cut usually results in a company’s stock price dropping and can cast doubt on a company’s management. However, at times, the company has to cut its dividend in an effort to solidify the company’s balance sheet.
The important thing for investors to understand is why the company is issuing the dividend cut. Once they do, they will have a better understanding of whether they should continue to invest in the company.