There are two main ways to earn money when investing in the stock market: by capitalizing on the appreciation in the value of a stock, and by owning the stock of companies that pay dividends.
Dividends are payouts of retained earnings by companies to investors who own its stock. They are essentially a way for companies to distribute some of their profits to shareholders, and they can increase the overall return of a security over the long term.
In general, dividends tend to be paid out by older and more established companies that are no longer in a high-growth stage, and thus no longer need to pour all of their earnings back into the business to fuel growth. They are also paid by companies that tend to accumulate large amounts of cash for one reason or another.
Do Not Overreact
Companies that pay dividends to shareholders will periodically raise or lower the amount of dividend that is paid. If you own a dividend-paying stock, what should you do if the company announces a dividend reduction or raise?
In either scenario, it is important not to overreact. A dividend cut is not necessarily a red flag that there might be problems with the company, while a dividend raise does not necessarily signal good news. In other words, dividend cuts and raises in and of themselves are not a reliable indicator of a company’s financial health or whether or not its stock is a good investment.
There are many possible reasons why companies lower and raise their dividends. A reduction in dividend payments reflects a change in fiscal policy indicating that the company wants to retain more capital, as opposed to distributing capital to shareholders. This could be for positive reasons, like increasing investments in plant and equipment, creating new products or acquiring a competitor in order to grow. On the other hand, it could be for negative reasons — for example, the company is over-leveraged, its expenses have risen or its earnings are falling.
Therefore, the first thing to do if a company you own announces a dividend cut is to try to find out why. A good starting place is to study the press release that announced the cut — it should be posted on the company’s website. The press release should explain why the cut was made, hopefully in clear language that is easy to understand.
If the press release is not clear in its explanation, you might need to dig a little deeper by studying the company’s financials (which you should also be able to find on the company’s website). Start with the balance sheet: Look specifically for how much debt the company has compared to cash. Long-term debt should be less than half the amount of cash currently on hand. If it is more than this, the company could be severely impacted by a sales or earnings slowdown.
Anticipating Dividend Cuts
By carefully following the investing news as it relates to the company, you should be able to anticipate dividend cuts. For example, if the company has recently announced a large loss or series of losses, there is a strong chance that it will soon announce a dividend reduction.
Two other things to watch for when it comes to dividends: Are dividend payouts made on time, and is the dividend payment increased on an annual basis? Since dividends are usually paid according to a schedule, late payouts could indicate problems with the company. The same goes for companies that are not increasing their dividends each year, which is standard practice among most dividend-paying companies.
With regard to dividend increases, these are usually a sign that the company is financially healthy and enjoys a strong cash position. As noted, annual dividend increases are common for healthy companies. By increasing its dividend, companies are sending a message to investors that they are financially sound and their cash flow is strong.
Minimize Losses, Boost Returns
Investing in dividend-paying companies can be a good way to increase the overall return on your equity investments. Dividends can help minimize losses when the stock price falls while boosting return when the stock price rises.
However, it is usually wise not to read too much into dividend reductions or raises. These are common financial strategies employed by companies for a variety of different reasons. If you are concerned, do some research to find out specifically why the dividend was lowered or raised — and then make your investment decisions based on facts, rather than conjecture.