Dividends form a significant part of a company’s strategy and investment case. Paying dividends is treated as a sign that a business is financially healthy – although, don’t judge a company’s financial strength solely based on dividends. Dividends provide a steady return to potential investors. Without dividends, shareholders must rely on share price appreciation as the sole the only way of turning a profit.
The attractiveness of some companies highly depends on the dividend. Take utility companies as an example. Supplying electricity and gas is a highly regulated industry and, although stable, provides limited opportunity for growth. Revenue rarely experiences large movements year-on-year (YoY) and profits tend to be more stable. Although you could argue this means they have less potential than other stocks and are rather boring, they tend to be the most reliable dividend payers in the market. These types of stocks are referred to as income stocks.
Companies place a different priority on dividends. Some, such as investment companies, put shareholder returns at the top of the list while others only prioritise payouts once other needs are met, such as capex.
Dividend policies provide a clear path for investors to follow and tells the market what to expect. By adopting a policy, a company is committing to make some form of return to shareholders on a regular basis. Like any target, delivering dividends as promised suggests a business is meeting its goals, but if it fails to keep its promises then shareholders can be quick to turn on the business.
It is important to remember that companies are under no obligation to pay dividends to shareholders and that payouts can become vulnerable rather quickly. If a business is deteriorating and needs to tighten the purse strings then the dividend is a logical place to start to make savings. Equally, if business is booming then dividends are a logical way of returning excess cash to shareholders, which don’t like to see money sat idle in the bank and not being spent.
Investors know what to expect if a dividend policy is in place and can forecast where future payouts are headed depending on the company’s forecasts or prospects. A policy can also help businesses better plan their spending. However, if a company does not have a suitable policy in place then it can find itself unable to fulfil its promises, and shareholders do not take kindly to U-turns. Having said that, sticking to a policy when you can ill-afford it runs the risks of having to fund payouts using debt and delaying the problem.