A public or private corporation's dividend policy results from decisions by management and the board of directors over how much cash flow should be used to return to stockholders. Dividends typically take the form of quarterly checks, but can also be distributed in additional company stock. They are a key barometer of a company's health, and how investors perceive them directly affects the stock price.
Use of Cash Flow
A high-growth company may choose to invest all of its free cash flow into the business rather than return money to shareholders. Seeking to take advantage of bright prospects and gain an edge on the competition, a corporation will deploy all available resources to growth. Investors recognize this reality and often reward such companies with a high stock price despite the lack of dividends. Once businesses become well established and growth begins to slow, they may initiate or increase dividends, actions that also support stock prices.
Cause and Effect
A company typically announces a dividend increase in the same press release as a positive quarterly earnings report. The combination of both favorable events often leads to an immediate increase in the share price, even on days when the overall market may be down. The announcement of a dividend cut may lead to the expected stock price decline, but it could also signal that a company is taking the necessary steps to reduce debt and put its financial house in order. Even painful reports can be perceived positively if they point to future benefits.
The management of a well-run company is intimately familiar with all key details and economic circumstances. They are thus in a prime position to initiate dividend increases, which offer a strong signal to the marketplace that the business expects a sustained increase in earnings going forward. Managements and boards are loath to cut dividends, so they generally prefer to keep dividends steady even in the wake of an uptick in earnings if there is any doubt about cash flow. On the downside, bank balances do not lie, so if a company no longer has the cash to maintain its current dividend, it will have to announce a cut that invariably leads to a lower stock price.
Corporate management generally has wide latitude in deciding when to increase dividends and by how much. Over time, investors learn to trust this discretion in light of a strong track record. Managers, however, may focus on risky projects or acquisitions that require large cash allocations at the expense of higher dividends. While the free-market system is inherently risky, a company's cash belongs to its stockholders; if they believe assets are not being used wisely, the stock price will suffer.
Robert Rimm graduated from the University of Pennsylvania and founded 88keys.com to provide education, writing and communications services for clients within the nonprofit, arts and education communities in the United States, Europe and Russia. His key interests include art and culture, social entrepreneurship, education, the environment and human rights. He is fluent in French and Russian, and is a widely published author.