Dividends are distributions that many companies pay out regularly to shareholders from earnings. They send a clear, powerful message about future prospects and performance. A company’s willingness and ability to pay steady dividends over time and its power to increase them provide good clues about its fundamentals.
Before companies were required by law to disclose financial information in the 1930s, a company’s ability to pay dividends was one of the few signs of its financial health. Despite increased transparency, dividends still remain a worthwhile yardstick of a company’s prospects.
Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the profits and reinvest them into the business.
For these reasons, few “growth” companies pay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and handle contingencies.
The progression of Microsoft through its life cycle demonstrates the relationship between dividends and growth. When Microsoft was a high-flying growth company, it paid no dividends, but reinvested all earnings to fuel further growth. . Eventually, it reached a point where it could no longer grow at the unprecedented rate it had maintained for so long. So, instead of rewarding shareholders through capital appreciation, the company began to use dividends and share buybacks as a way of keeping investors interested.
Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price. The dividend yield measures the amount of income received in proportion to the share price.
If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming.
Dividends do matter because profits on paper say one thing about a company’s prospects; profits that produce cash dividends say another thing entirely.