Summary: This section of the site looks at the way companies pay a dividend, how that payment is viewed by the stock market and investors and the impact on valuation. Clearly, dividend policy is very important to the market - and it should therefore be important to us all!
Analysts use a number of methods to value and assess companies. The way a company returns money to shareholders offers useful insights into the valuation and potential return an investor might receive.
It is also used a reflection of the industry or sector the company is in. The companies in some sectors literally throw off cash! For example, with a high oil price, the 'majors' literally pump money from the ground. There is an almost limitless demand for their product but supply is not so elastic and so there is often more demand than supply and a strong or rising price. Such companies are expected to pay out a portion of these profits every year to investors and are therefore some of the main holdings in 'income' funds around the world.
Some of the other 'defensive' sectors that earn bigger than average returns - and thus pay out more to shareholders - include other energy companies, utilities, pharmaceuticals and tobacco companies.
There are a number of ratios based on accounting methods which are used to calculate returns relative to the dividend being paid. These can help to estimate the future cash flow to the investor from a stock.
In the UK, for example, they are usually paid every six months. The first is known as an interim dividend, whilst the second is known as the final dividend.
These payments can be the same size or of different amounts. If the interim and final dividends are for different amounts though, it is usually the final which is the larger sum.
Since the payments from a holding can be a large or at least significant portion of long term returns, it is useful for an investor to gain a working knowledge of this subject.
It is worth noting that as a stock market rises, the capital gains being accrued by investors tend to make company directors less inclined to make payments from their cash reserves. This means that annual dividend payments often stand still for a number of years while the company value is rising. The income paid out is therefore a smaller element of an investors annual return.
There are other companies that pride themselves on paying out an increasing amount every year. In the US, these firms are tracked in their own mini index known as the 'Dividend Aristocrats'.
The time to buy
Perceptive readers will be realising that there are some points in the economic cycle that make investment much easier to get right and therefore, more profitable. That point? When prices are low - usually after a recession - but set to rise because of a strengthening economic outlook. Investing in strong firms with good brands ought to pay off handsomely then.
At this point in the cycle, prices will tend to rise and annual payments ought to be easier to make, finance ought to be getting cheaper (making growth more possible) and so the stage should be set for strong returns inside portfolios.
The return on the majority of collective investment funds is not usually impacted much by individual corporation's dividend policies. This is because of the large number of holdings such a fund would control.
However, there are investment funds (mutual funds / unit trusts / sicavs) that only select corporations that pay above average returns. These funds are designed to pay out a proportion of their income each year - and therefore are targeted at investors that need to draw an annual income. These investors might be the retired or nearly retired on a fixed income, or anyone with known expenditures due for which the income from the fund will help to pay.
Remember that investment is a long term game. Very few investors
actually double their money in a 12 month period, which means that it
pays to look closely at the extra boost that a dividend will provide.
Another very important point to remember is that it is vital to reinvest
your dividends should you have the opportunity. Many big firms now
offer a reinvestment plan which allows the investor to purchase more
shares in their firm each year with the annual dividend payment. This
helps to make the shareholders long term owners rather than quick
turnaround traders and also makes it easier and lower cost to reinvest.
Research suggests that long term reinvestment can make a difference of several percentage points per year difference over the longer term.
There are a number of schools of investment theory that recommend selecting companies to invest in by assessing their annual payments to shareholders. These have some real merit.
When businesses are compared closely, there are some that literally throw off cash and profits and can afford to pay significant amounts out to shareholders every year. And there are other businesses that simply will never manage this. In large part, this relates to the economics of the business model and sector, despite how management insist that it relates to their own superior skills...
These businesses that make truckloads of money are usually priced more highly in the stock market and have a higher price to earnings ratio. Their ability to reward shareholders is a significant part of this as is described in this guide.
The following pages will look at the issue in more depth:
The Definition Of A Dividend
Dividend Policy And Dividend Cover
Understanding And Calculating A Dividend Yield
How High Is A High Dividend Yield?
Building A Dividend Portfolio
How Does A Scrip Dividend Work And What Is A Scrip Issue?