"The only thing that gives me pleasure is to see my dividend coming in." --John D. Rockefeller.

One of the simplest ways for companies to communicate financial well-being and shareholder value is to say "the dividend check is in the mail." Dividends, those cash 澳洲幸运5官方开奖结果体彩网:distributions that many companies pay out regularly from 澳洲幸运5官方开奖结果体彩网:earnings to stockholders, send a clear, powerful message about future prospects and performance. A company's willingness and 澳洲幸运5官方开奖结果体彩网:ability to pay steady dividends over time – and its power to increase them – provide good clues about its 澳洲幸运5官方开奖结果体彩网:fundamentals.

Dividends Signal Fundamentals

Before corporations were required by law to disclose financial information in the 1930s, a company's ability to pay dividends was one of the few signs of its 澳洲幸运5官方开奖结果体彩网:financial health. Despite the 澳洲幸运5官方开奖结果体彩网:Securities and Exchange Act of 1934 and the increased 澳洲幸运5官方开奖结果体彩网:transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company's prospects.

Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, it often keeps the profits and 澳洲幸运5官方开奖结果体彩网:reinvests them into the business. For these reasons, few 澳洲幸运5官方开奖结果体彩网:"growth" companies pay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and🔯 handle contingencies🦄.

Dividend Example

The progression of Microsoft (MSFT) through its 澳洲幸运5官方开奖结果体彩网:life cycle demonstrates the relationship between dividends and growth. When Bill Gates' brainchild was a high-flying growing concern, it paid no dividends but reinvested all earnings to fuel further growth. Eventually, this 800-pound software "gorilla" reached a point where it could no longer grow at th🅰e u🦩nprecedented rate it had maintained for so long.

So, instead of rewarding shareholders through 澳洲幸运5官方开奖结果体彩网:capital appreciation, the company began to use dividends and share buybacks as a way of keeping investors interested. The plan was announced in July 2004, nearly 18 years after the company's IPO. The cash distribution plan put nearly $75 billion worth of value into the pockets of investors through a new 8-cent 澳洲幸运5官方开奖结果体彩网:quarterly dividend, a special $3 澳洲幸运5官方开奖结果体彩网:one-time dividend, and a $30 billion 澳洲幸运5官方开奖结果体彩网:share buyback program spanning four years. In 2022, the company is still paying dividends with a yield of 0.87%.

The Dividend Yield

Many investors like to watch the 澳洲幸运5官方开奖结果体彩网:dividend yield, which is calculated as the annual dividend income per share divided by the current 澳洲幸运5官方开奖结果体彩网:share price. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (1) the share price is high because the market reckons the company has impressive prospects and isn't overly worried about the company's dividend payments, or (2) the company is in trouble and cannot afford to pay reasonable dividends. At the same time, however, a company with a high dividend yield might be signaling that it is sick and has a 澳洲幸运5官方开奖结果体彩网:depressed share price.

The dividend yield is of little importance when evaluating growth companies because, as we discussed above, 澳洲幸运5官方开奖结果体彩网:retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of 澳洲幸运5官方开奖结果体彩网:capital gains (think Microsoft).

Dividend Coverage Ratio

When you evaluate a company's dividend-paying practices, ask yourself if the company can afford to pay the dividend. The ratio between a company's earnings and the net dividend paid to shareholders—known as dividend coverage—remains a well-used tool for measuring whether earnings are sufficient to cover dividend obligations. The ratio is calculated as 澳洲幸运5官方开奖结果体彩网:earnings per share divided by the 澳洲幸运5官方开奖结果体彩网:dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut, which can have a dire impact on 澳洲幸运5官方开奖结果体彩网:valuation. Investors can feel safe with a 澳洲幸运5官方开奖结果体彩网:coverage ratio of 2 or 3. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects startꦯ to look risky. If the ratio is under 1, 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 5, investors should ask whether management is withholding excess earnings and 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 sta🧜ble.

The Dreaded Dividend Cut

If a company with a histo𝔉ry of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming.

While a history of steady or increasing dividends is certainly reassuring, investors need to be wary of companies that rely on borrowings to finance those payments. Take, for example, the 澳洲幸运5官方开奖结果体彩网:utility industry, which once attracted investors with reliable earnings and fat dividends. As some of those companies were diverting cash into expansion opportunities while trying to maintain dividend levels, they had to take on greater debt levels. Watch out for companies with 澳洲幸运5官方开奖结果体彩网:debt-to-equity ratios greater than 60%. Higher debt levels often lead to pressure from Wall Street as well as from 澳洲幸运5官方开奖结果体彩网:debt-rating agencies. That,🦩 in turn, can hamper a company's♓ ability to pay its dividend.

Great Disciplinarian

Dividends bring more discipline to the management's investment decision-making. Holding onto profits might lead to excessive 澳洲幸运5官方开奖结果体彩网:executive compensation, sloppy management, and unproductive use of assets. Studies show that the more cash a company keeps, the more likely it is that it will overpay for 澳洲幸运5官方开奖结果体彩网:acquisitions and, in turn, damage 澳洲幸运5官方开奖结果体彩网: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. Furthermore, companies that pay dividends are less likely to be 澳洲幸运5官方开奖结果体彩网:cooking the books. Let's face it, managers can be awfully creative when it comes to making earnings look good. But with dividend obligations to meet twice a year, 澳洲幸运5官方开奖结果体彩网:manipulation becomes that much more challenging.

Finally, dividends are public promises. 🧔Breaking them is both embarrassing to management and damaging to share prices. To tarry over raising dividends, never mind suspending them, is seen as a confession of failure.

A Way to Calculate Value

Another reason why dividends matter is dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the 澳洲幸运5官方开奖结果体彩网:underlying value of a share, and it is a staple of the 澳洲幸运5官方开奖结果体彩网:capital asset pricing model which, in turn, is the basis of 澳洲幸运5官方开奖结果体彩网:corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, "discounted back" to their 澳洲幸运5官方开奖结果体彩网:net present value. As dividends are a form of 澳洲幸运5官方开奖结果体彩网:cash flow to the investor, they are an important reflection✱ of a company's value.

It is im♍portant to note a♈lso that stocks with dividends are less likely to reach unsustainable values. Investors have long known that dividends put a ceiling on market declines.