Dividends are corporate profits that a corporation elects to pay out to its shareholders. Dividends are at the discretion of a corporation: it can start, end, increase, decrease, omit or suspend them at any time. Dividend decisions are made by the board of directors. Dividends are typically paid quarterly. A dividend increase is usually welcomed by the shareholders because it is cash in their pockets. A corporation may have several reasons to increase dividends.
The most common reason to increase dividends is to share the profits with the shareholders. A corporation needs money to expand and grow, so it rarely pays out all profits in dividends, but it may have a particularly good year where it has generated more profits than it needs for its operations, so it decides to pay out more in dividends.
Bolster Stock Price
A dividend increase often pushes up the stock price. For example, a corporation pays a $1 annual dividend, and its current stock price is $20, meaning that its current dividend yield is 5 percent ($1 ÷ $20). If the dividend is increased by 10 percent to $1.10, the market will adjust the stock price to continue to yield 5 percent, that is to $22 ($1.10 ÷ $22 = 5%) because investors are willing to pay more for a higher dividend. By increasing the dividend by 10 cents, the corporation effectively boosted the stock price by $2, so the net benefit to the shareholders of a 10-cent dividend increase was $2.10 per share.
Some corporations in mature industries such as utilities have a long history of dividend increases. These companies generate ample cash from operations, which they do not really need to grow, so a profit increase usually results in a dividend increase. Investors in high dividend-paying stocks expect those increases (that’s why they own those stocks in the first place) so the corporation simply does what has traditionally been expected of it. Sometimes a company may have lower profits for a year but will still increase the dividend just to live up to its reputation, hoping that the next year it will make up for the shortfall.
Dividend Yield vs. Increase
Many investors hunt for the highest dividend-yielding stocks, but the real value is in dividend increases, because if a stock you own increases dividends faster than the rate of inflation, you in effect own an asset that produces a rising income stream that provides protection against inflation. Knowing that, corporations may pay fairly small dividends as measured by dividend yield (for example, 1 percent) but increase them at a rate higher than the rate of inflation.
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- “PassTrak Series 7: General Securities Representative License Exam;" Dearborn Financial Services; 2003