What Are Dividends?
Dividends are a portion of a company’s earnings that are being paid to the shareholders of the business.
A consistent record of steadily growing dividend payments can be a good indicator of solid financial health and positive future prospects for the business.
This is why dividends attract many investors who are looking for financially sound and mature businesses or just prefer to receive a regular income from their investments.
Not every company decides to pay dividends. Some types of businesses such as growth companies usually prefer to reinvest all profits back into the business in order to maximize growth, which would result in a more rapid business expansion that would benefit both the company and its owners in the long run.
Most companies that pay out dividends also seek out to keep their dividend payments on a consistent basis while regularly increasing their dividends from year to year. Good examples for companies that have a history of growing dividends are PepsiCo (PEP), Coca-Cola Co (KO), Johnson & Johnson (JNJ), and AT&T (T).
Why Do Companies Raise Dividends?
There are several reasons and incentives that companies could have to frequently increase dividend payments.
Sending Out a Message to Investors
An increasing record of dividend payments suggests that the business is in solid financial shape and that shareholders can continue to count on the company’s performance in the future. This wouldn’t only increase the confidence of existing shareholders but also raise demand for the stock which would result in an increasing stock price.
Some companies will still decide to continue paying dividends (for example by using money from non-earnings sources) even if the business faces financial hardships in order to encourage investors to stay within the business despite the negative outlook.
This generally shows how trustworthy and effective a company truly operates, and should raise serious concern to investors.
An Increase in the Company’s Profits
Since dividends are a proportion of a company’s profits that are distributed to the shareholders, companies mostly decide to increase their dividend payment as a result of positively growing profits for the given time period.
For example, when a business had a good year with increasing profits, it may enable them to pay out more cash to shareholders as a token for their ownership in the company. This is the primary reason why increasing dividends are a good indicator of a company’s positive performance.
On the other hand, if a company is facing poor financial results and declining earnings over time, it might cut its dividend payments as the business may no longer be able to sustain the same amount of dividends as it had paid before. Cutting dividends is usually one of the first options to choose when companies have to face financial difficulties.
A Change in the Growth Strategy of the Business
Companies that pay dividends generally do so because their financial position allows them to pay dividends, or because they simply don’t see any better use with the additional profit than to pay it out as a dividend to the shareholders.
For instance, mature companies will generally have less growth potential since they have already grown their market share to a limited proportion in their industry. This usually leads companies that have already gone through their rapid growth phase to pay increasing dividends as an alternative way to return profits back to shareholders.
As a result, companies that are steadily increasing their dividends, are usually already established businesses that aren’t likely to grow as rapidly as younger companies and thus distribute a considerable amount of profits to shareholders instead.
How Does an Increased Dividend Affect Shareholders?
Companies that have an attractive history of dividend payments are usually more popular among investors since that shows how predictable and financially stable the business has been and is likely to be in the future.
Most companies pay their dividends on a quarterly basis, meaning four times a year. If a business increases its dividend payments, shareholders would essentially obtain more money in the given time period than in previous years.
An increase in dividends generally doesn’t have a direct impact on stock prices but certainly could make a stock more attractive to investors.
One of the most common dividend metrics that investors look at is the dividend yield of a stock. The dividend yield is a percentage that reflects how much dividends you would receive relative to the price of the stock.
»Learn more about the dividend yield of stocks
You can simply calculate the dividend yield of a stock by dividing the dividend that the company pays annually by the current price of the stock.
For instance, let’s assume that company XYZ pays a dividend of $2.5 annually. The stock is trading at $50. If we divide $2.5 by $50, we would come up with a dividend yield of 5%, meaning that we could expect to receive about 5% of the current stock price as a dividend annually if we bought the stock right now.
An increase in dividend payments by a company would automatically result in a higher and more attractive dividend yield for the stock. If company XYZ decides to raise its dividends from $2.5 to $3 annually, the dividend yield would be 6%.
More investors would now be encouraged to buy the stock at a more attractive dividend yield, leading the stock price to increase. As a result, shareholders that were already invested in the company before would benefit from capital appreciation.
Conclusion
When a company announces a dividend increase, it generally sends out the message to investors that the business is in good financial condition and optimistic about future prospects.
Companies usually raise dividend payments along with increasing earnings, as additional earnings would allow businesses to pay higher dividends than previous years.
Mature companies are the most likely to pay steadily growing dividends as an alternative way of returning profits to investors instead of offering substantial growth. Companies may choose to pay increasing dividends as a result of fewer options to use that capital otherwise effectively in the first place.
