A company might increase its dividend for a number of different reasons. Since a dividend represents a portion of company profits that is being paid to shareholders, news of a dividend increase is typically viewed as a positive development because it suggests that the company is confident in its future.
However, a dividend increase can also be a sign that the company is running out of growth opportunities and is decided to, rather than invest, distribute some of its excess cash flow to shareholders.
Key Takeaways
- Dividends represent company profits that are paid to shareholders.
- When a dividend increase is the result of improved cash flows, it is often a positive indicator of company performance.
- Another reason for a dividend hike is a shift in company strategy away from investing in growth and expansion.
- A company might also raise its dividend to attract additional equity investments by offering more attractive dividend returns to investors.
- A stable dividend payout ratio is typically viewed as a positive sign.
Dividend Increases
There are two primary reasons for increases in a company’s dividend per share payout.
- The first is simply an increase in the company's net profits out of which dividends are paid. If the company is performing well and cash flows are improving, there is more room to pay shareholders higher dividends. In this context, a dividend hike is a positive indicator of company performance.
- The second reason a company might hike its dividend is because of a shift in the company’s growth strategy, which leads the company to expend less of its cash flow and earnings on growth and expansion, thus leaving a larger share of profits available to be returned to equity investors in the form of dividends.
There are a number of reasons why a company might decide to reinvest a smaller portion of its profits into growth and expansion projects. Depending on the size of the company, production capabilities, and similar factors, the extent to which a company can grow may be at least temporarily limited. The company might be concerned about its ability to increase production sufficiently to meet increasing demand if it pushes too far, too quickly in expanding its market.
Unfavorable financing rates may also lead the company to postpone major capital expenditures. A rapidly growing company may wish to consolidate its gains and reassess its market position before committing further funds to expansion. There is also the possibility a company may decide to increase its dividend payout to attract further equity investment by offering more attractive dividend returns to investors.
Dividend Yield vs. Dividend Payout
The two main dividend-related equity valuation metrics used to evaluate a company's overall investment potential and specific income investing potential are dividend yield and the dividend payout ratio.
While dividend yield is perhaps a more commonly viewed figure by retail investors, the dividend payout ratio is a metric that is favored by some savvy investors. The dividend payout ratio shows the percentage of a company’s earnings being paid to shareholders in the form of dividends. On the other hand, dividend yield is computed by dividing the annual dividend per share by the current share price.
A stable dividend payout ratio over time is considered a favorable sign for investors, as it indicates a financially sound company with earnings adequate to support continued positive dividend yields for investors. Analysts prefer the payout ratio to dividend yield, as a company's current yield is subject to the whims of the market and may be an unsustainable figure over the long term.
The Bottom Line
Companies that increase their dividends send a positive signal to investors and analysts that the company can maintain growth and profitability into the future. As a way to distribute profits to shareholders, dividend increases can attract new investors who seek income in addition to capital gains in their portfolio. Investors should pay attention to the dividend yield, which is dependent on the stock's price versus the payout ratio, which has to do with earnings instead, when making decisions to invest in a dividend stock.
