Dividend Payment Brings Regulation to Investment Decision Making

by October 24, 2018 0 comments

Dividend Payment Brings Regulation to Investment Decision MakingIn the form of a dividend check as evidence of the financial well-being of any company can, now, go a long way in boosting the growth of the company and its employees.

John Rockefeller, founder of the Standard Oil Company had  once said, “Do you know what gives me pleasure? It’s to see my dividends coming in?” It is true that dividends and cash payments that companies pay to the stockholders from their earnings are a good news for both investors and the companies themselves. It gives a feel-good factor and communicates the intention and ability of the company to share its earnings with the investors instantly. It also gives clues about the strong fundamentals and financials by paying steady dividends over time with a possibility to increase them in future.

From the time when companies were not required to disclose financial information to the stockholders to the modern times now, with increased transparency, dividends still remain a worthwhile yardstick to measure a company’s present performance and future prospects. But does that mean that companies which do not pay out dividends are fundamentally weak? However, on the contrary, they may be growing and performing extremely well.

Companies can have four different dividend policies. First, regular dividend policy is a type of dividend policy where investors, who want regular income, get dividend at a usual rate. This type of dividend payment can be maintained only if the company has a regular earning. Second, stable dividend policy can be further classified as constant dividend per share and constant payout per share. Third, in irregular dividend policy, companies do not pay regular dividends to the shareholders. And finally, companies with no dividend policy may have requirements of funds for further growth.

Another approach of dividend payout is a combination between the residual and stable dividend policy. Using this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-term goal. In today’s markets, this approach is commonly used by companies that pay dividends.

Generally, mature companies with stable earnings issue dividends as they do not have much options to reinvest their earnings, and investors, who are risk-averse and require steady income associated with dividends, are more likely to buy such stocks. These type of stocks are ideal choice for an older or a retired investor as the risk associated with these type stock is low. Even young people who want to balance the decline in stock price with dividend can also invest in such stocks.

Worldwide companies like Apple, Microsoft, Exxon Mobil, Wells Fargo and Verizon payout regular dividends. Indian companies like Coal India, Hindustan Petroleum Corporation, Indian Oil Corporation, National Mineral Development Corporation, Oracle Financial Services Software and Hindustan Zinc have the record of paying the most consistent dividends. Since high- dividend paying stocks may not be the best, independent research before investing in these stocks is crucial and one should consider several aspects while investing in dividend stocks. These include a healthy track record for regular dividends; a higher dividend yield, at least to beat the inflation; and future growth prospects.

Investors need to be careful in understanding the valuation of dividend stocks. Although, generally the dividend-yielding stocks are cheaper, yield-hungry investors might, in some situations, increase the share prices. Rushing blindly into a dividend stock purchase based solely on its yield is risky, particularly since it could be the result of a depressed stock price born of poor operating performance. This is clear when looking at the formula for dividend yield: Dividend yield = Dividend/Share Price. If the dividend amount rises faster than the share price, the dividend yield can stay constant or increase. However, while dividends can grow as an offshoot of a company’s performance, yield can also increase if a company’s share price falls by half. While the former is an attractive scenario for an investor, the latter is a blaring red flag.

Additionally, while evaluating a company’s dividend-paying practices, investors should examine the dividend-paying capacity of the firm. The ratio between a company’s earnings and net dividend paid to the shareholders — known as dividend coverage, which is the ratio of earnings per share and dividend per share — remains a well-used tool for measuring whether earnings are sufficient to cover dividend payouts.

A healthy dividend coverage ratio is between two and three and when coverage gets thin, odds are good that there will be a dividend cut, which can have a dire impact on valuation. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under one, the company is using its retained earnings from last year to pay this year’s dividend.

At the same time, if the payout gets very high, say above five, investors should ask whether management is withholding excess earnings, not paying enough cash to shareholders. Managers who raise their dividends are telling investors that the course of business over the coming 12 months or more will be stable. Further, while investors tend to view companies that pay dividends as boring but reliable stewards of shareholder capital, these payouts aren’t necessarily the best sign of a strong company.

According to a research by William Thorndike, a private equity investor, who delved into the management habits of top CEOs, contrary to conventional wisdom, those CEOs who avoided dividends ultimately delivered stronger performance.

While dividends and stock buybacks have been the staple demands of activist investors in the last few years — as they push company managements to unlock more value for shareholders — it can also throw light on those managers struggling to unlock growth. Take General Electric for example, an American stalwart whose yield at 4.2 per cent seems attractive, the company has been struggling with an ongoing restructuring, weakness in operations and management upheaval. Paying out big dividends can also be a sign that the company believes that there isn’t much to invest within the business and there are fewer opportunities to grow by acquiring other companies or using that cash in any other way.

On the other hand, a company that is still growing rapidly usually won’t pay dividends because it wants to invest as much as possible into further growth. Even a mature firm that believes it will do a better job of increasing its value by reinvesting its earnings, will choose not to pay dividends. Companies that don’t pay dividends might use the money to start a new project, acquire new assets, repurchase some of their shares or even buy out another company.

Firms that choose to reinvest all of their earnings instead of issuing dividends, may also be thinking about the high potential expense of issuing new stock. To avoid the risk of needing to raise money this way, they choose to keep all of their earnings. A company may also choose not to pay dividends because the decision to start paying dividends or to increase an existing dividend payment is a serious one. A company that eliminates or reduces its existing dividend payment may be viewed unfavourably and its stock price may decrease.

The choice to not pay dividends may be more beneficial to investors from a tax perspective. Usually dividends are taxable to investors as ordinary income. Some well-known companies that historically have not paid dividends to shareholders include Facebook, Alphabet, Amazon, Biogen, and Tesla. The senior management of these firms believe that instead of paying dividends to shareholders, who may not have enough investment opportunities to reinvest their cash dividends, any firm can reinvest on their behalf instead of paying out dividends as they would have better options to reinvest. This can ultimately be visible in an increased share price and contribute to capital appreciation.

The opportunities available to firms are reinvesting in their own operations and pursue organic growth and acquisition of other companies or repurchase shares. The proponents also feel that paying out dividends can have two disadvantages: Different investors may desire different levels of payouts; and a dividend received is taxed as income, which long-term investors may not want. Furthermore, introducing a dividend may turn off investors who do not want dividends.

Dividend payment is a great disciplinarian and brings about a regulation to the management’s investment decision-making. Holding onto profits and not distributing them to the shareholders may lead to unhealthy practices like excessive executive compensation, and unproductive uses of assets like over-paying for acquisitions and further damaging shareholder value.

In fact, companies that pay dividends tend to be more efficient in their use of capital than similar companies that do not pay dividends and are less likely to cook the books. The bottom line is that dividends matter significantly and the evidence of financial well-being of a company in the form of a dividend check can go a long way in boosting the morale of investors. As they say, a bird in hand is worth two in the bush.

(The writer is Assistant Professor,Amity University)

Writer: Hima Bindu Kota

Courtesy: The Pioneer

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