I recently overheard a conversation regarding the view that a consistent dividend makes a company a good investment. This got me thinking about whether or not that was entirely true and what caveats ought to be included in such a statement. Before we move on, let me pause and define what a dividend is. When a company is doing well it may want to distribute a portion of the earnings to its shareholders. It does this by paying a dividend either in the form of a cash payment or shares of stock. It’s important to note that in a vacuum, a dividend payout decreases a stock’s price by the amount of the payout, however, this is difficult to observe in reality because the stock price is always moving. Because a dividend is intended to reflect strong earnings, investors have historically taken this as a sign of a healthy company and many individuals nearing retirement have loaded up on dividend-paying stocks as a means to generate income to live off of.
Why then, should we be cautious of the story dividends are trying to tell. The choice to payout a dividend typically lies with a company’s executives who are also typically incentivized to uphold their company’s stock prices. In order to do so, they want to manage investor sentiment towards their company. They know that if they offer a dividend it will encourage investors to believe that the company is doing well, which has the potential to increase the stock price. They also know that if they cut a dividend, it will send the message that the company is in trouble, causing the stock price to plummet. Because of this, there exists a misalignment of interests. For the health of a company, there may be times when executives need to cut a dividend to conserve cash but they may be unwilling to do it because of the panic it may cause among investors. Likewise, executives may be wary of increasing a dividend for fear that they may not be able to sustain it.
The important thing to remember is that there is more to a company’s financial picture than how big its dividend is. Just like there is more to a company’s financial picture than its current hit product or what you hear about it in the news. As always, it pays to be skeptical, pursue information from a variety of resources, and educate yourself as much as possible when it comes to investing. If you'd like to learn more about this topic I'd invite you to check out a similar article written by my brilliant boss.
*This article was originally published September 20, 2017 on cedarstonecupcakeclub.com.