It’s been said that a dividend is a way for investors to collect rent on the equities they own. So when the dividend per share rises, investors benefit with increased income. And if investors reinvest their dividends through a dividend reinvestment plan, they benefit from the compounding effect.
Since a dividend is a payout given to shareholders out of a company’s profits, an increase to the dividend shows that the company is confident that it will continue to grow earnings and puts a high value on increasing shareholder equity. However, it can also mean that the company’s business model is changing and they are choosing to return a higher percentage of their dividends into increasing shareholder equity rather than investing in growth.
In this article, we’ll review what a dividend increase can mean and why it’s important for investors to know the difference between a dividend yield and the dividend payout.
Why Does a Company Increase its Dividend Payout?
When a company increases its dividend, they do so, primarily, for one of two reasons:
- Net profits increased – This generally suggests strong revenue performance and increasing free cash flow (FCF). This gives the company the flexibility to reward shareholders with a higher dividend. This is the best kind of dividend increase.
- Less viable options - Sometimes a company has grown to the point where spending on growth and expansion is not a viable option. In this case, they may choose to payout a larger share of their profits in the form of a dividend. This option will require more exploration.
When a company chooses to pay out less of its profits on growth and expansion, it could be as simple as that the company is in a regulated industry where they have limited pricing power. Utility companies are a good example of this. Another reason a company may opt to pay a higher dividend is that interest rates are rising. This increases borrowing costs and may make it impractical to fund capital expenditures.
There can be more concerning reasons that a company chooses not to reinvest in growth and expansion. One of these is that, depending on their size, their ability to grow may be limited. Another reason that can raise concerns is when a company increases its dividend payout as a way of attracting a larger equity investment.
Dividend Yield vs. Dividend Payout
Many investors get seduced by a company’s dividend yield. This is the dollar amount of a company’s current dividend per share on an annual basis divided by its current stock price. For example, if Walmart (NYSE:WMT) has a share price of $119.38 and an annual dividend per share of $2.24 its dividend yield would calculate to 1.88%. Because this number is based on current numbers, a dividend yield moves up and down frequently. This makes it a less reliable indicator of a dividend’s strength.
Dividend payout is the dollar amount per share that a company will pay shareholders on the payment date. Seeing this number remain stable or better yet increase should give investors more confidence that the company is on strong financial footing.
Understanding the Payout Ratio
The dividend payout lets you calculate a company’s payout ratio. The formula for calculating the company’s payout ratio is dividends paid divided by net income.
Company’s normally calculate several different payout ratios. Some of the most common include:
- Payout ratio based on trailing 12 months (TTM) of earnings
- Payout ratio based on the current year’s earnings estimates
- Payout ratio based on next year’s earnings estimates
- Payout ratio based on cash flow
Interpreting a company’s payout ratio will depend on several factors including the company and sector maturity. For example, investors would expect a company such as Walmart to have a higher payout ratio than Apple (NASDAQ:AAPL). Also, dividends can be industry specific. For example, a real estate investment trust (REIT) is required to pay out a significant portion of its earnings (usually more than 90%) as a dividend. However, even with that high payout ratio, investors may find other dividend stocks that are a better fit for their portfolio.
In most cases, a company is very reluctant to cut its dividend once it starts to issue one. A dividend cut usually results in a company’s stock price dropping and can cast doubt on a company’s management. Also, understanding what a company’s payout ratio means helps investors determine the sustainability of the dividend.