(January 4, 2011) When a company declares a dividend for its shareholders, essentially it means that a company is financially healthy. Dividend payments are made through companies’ retained earnings.  Generally, dividends are paid by mature, large cap stocks. Typically, these stocks belong to utility industry, consumer goods industry, infrastructure industry. On the other hand, “growth” stocks which have the potential to grow at a rapid pace prefer to retain earnings over dividends payments; as money is utilized back on investments. Typically, these stocks belong to “small cap” or “mid cap” stocks with tremendous growth potential. For instance: software, biotech stocks. However, it does not mean that mature companies pay all their retained earnings on dividends. For future growth, expansion, and capital investments, companies do keep some proportion (depending on their requirement) of retained earnings. And sometimes such companies may decide not to pay dividends if it has huge capital investment or project lined up for the future.

Investor’s Guide – The Dividend Yield

Investors often gauge a company through its dividends yield. A dividend yield is calculated by dividing dividend per share declared by current share price. Whenever a company declares low dividend yields compared to its peer group from the same sector then it generally indicates two scenarios; 1) the company is in good shape, its share prices are high and it is not preoccupied for paying high dividends. Such companies are fundamentally strong with good growth potential. 2) The company is not in good shape. It is unable to pay healthy dividends.

Be careful over massive Dividends cut

Sometimes, investors come across a situation where a company which was paying steady dividends suddenly decides to cut back its dividends payments. These are signs of trouble. As explained earlier, steady dividends are usually declared by companies in the mature industries. These companies, usually, have steady earnings and little R&D and growth expenditures. Hence, abrupt cut in dividends signal that trouble is ominous for a company. It either occurs due to fall in profitability or earnings. But even bigger danger is that such companies with flagging ROC look out for external borrowings to finance their operations.

 On the other hand, sometimes management keeps large amount of cash as reserves citing some reasons thereby, cutting the dividend payments. However, this can be counterproductive; as management can become complacent with large amount of cash. In such situation company can overspend on acquisitions, marketing campaigns etc which may result in shareholder’s value erosion.