The dividend-to-stock-price ratio represents one of the more accurate gauges of value when considering whether to purchase a particular common stock and at what price. The ratio is determined by dividing the dividend into the stock price. Earnings can be manipulated in many ways: influenced by receivables, creative accounting, deferred revenue and compensation, interest expense, taxes and other tools of the accountant's trade. Dividends, by contrast, are paid in cash (except in the rare instances of stock dividends) and companies cannot pay them unless the money is actually in the bank.
Regardless of the quarterly fluctuations in earnings that occur due to economic cycles, product success or failure, management brilliance or incompetence, and many other reasons, companies generally treat dividends as sacrosanct and are reluctant to reduce them for fear of signaling to the market that they are having cash-flow problems. Investors regard businesses that steadily increase their dividends from year to year as stable investments and are typically willing to pay more for their shares.
The dividend-to-stock-price ratio is akin to the yield on an interest-bearing security such as a CD or Treasury bond. If the declared dividend is $1 per year on a $20 stock, investors can expect a 5 percent return. If, however, money-market funds are paying 9 percent, that dividend my appear less attractive, especially given the inherent risk in any stock. The reverse scenario will make the dividend yield particularly attractive and companies may feel inclined to slow the rate of dividend increases when interest rates are at historic lows.
If the Catoire Corporation pays an annual dividend of $4 and its stock remains in the range of $200 per share, the ratio stands at 2 percent. To entice investors into a second look at an otherwise respectable company, it would have to increase its dividend or experience a significant drop in its share price. If the company's business remains intact but its share price traces a decline in the overall market and drops to $150, the dividend yield would substantially increase. Couple that with a decision by Catoire's board of directors to increase the dividend to $6 per share and a previously sleepy investment suddenly appears compelling.
The dividend-to-stock-price ratio often functions as a reliable indicator of investor sentiment and provides a tangible return beyond capital gains or losses if the underlying stock rises or falls. As with most indicators, however, this ratio is not fail-safe and the market is known to ignore rational behavior and unusually high or low yields. Investors thus use this ratio as one factor among many in making key portfolio decisions.
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.