What Is the Relationship Between Profits & Dividends?

Through stock market investments, it is possible to amass hundreds of thousands, if not, millions of dollars in wealth over the long term. When buying stocks, capital gains alongside dividends combine together to improve your total returns and net worth. Capital gains describe stock price appreciation, while dividends generate regular income for your portfolio. To invest strategically, it is important that you understand the relationship between corporate profits and dividend policy.

Corporations pay dividends to shareholders out of business profits. A corporation is therefore likely to increase its dividend payout alongside rising profits. To analyze business profits and dividend policy, you will read through a corporation’s annual report. Within the annual report, the corporation will break down profits and dividend payments through its net income and cash flow statements. You can order an annual report from a corporation’s investor relations department.

Dividends are generally paid and quoted quarterly in per share amounts. You will calculate dividend yield -- to better compare dividend payment and profitability trends of different stocks against each other. Dividend yields are similar to interest rates, as they calculate the amount of investment income that you can generate on one lump sum investment. To calculate dividend yield, you will divide a corporation’s expected annual dividend payments by its current share price. For example, Corporation Z may trade at $100 per share and offer a $1 quarterly dividend. The dividend yield on Corporation Z would then be 4 percent ($4 annual dividend / $100 share price).

Dividend payment policy varies according to industry and the separate stages within a respective business’ life cycle. In general, small corporations within rapidly developing industries, such as biotechnology and software, are likely to pay minimal dividends, if any. These companies can better serve their shareholders by reinvesting profits into the business to finance growth through research and development and equipment purchases. A mature company that is a market leader within an established industry, however, should pay a substantial dividend. A large company is afforded with fewer opportunities for growth and therefore returns greater portions of its profits to shareholders -- in the form of dividends. Large utility, oil and banking companies typically make significant dividend payments.

Contrary to bond interest, a corporation is under no legal obligation to pay out dividends. A corporation will sharply reduce its dividend and even eliminate the payout altogether, en route to bankruptcy. Large amounts of debt, combined with severe profit and share price declines often foreshadow a dividend cut and corporate bankruptcy. To manage financial risks, you should put together a diversified portfolio of stocks. For example, you could buy shares within oil, transportation and foreign companies. When oil prices rise, your oil company stock should generate strong returns and dividends. Alternatively, the transportation shares will perform well when energy prices fall, while foreign investments can pay dividends to stabilize the portfolio if the U.S. were to fall into a recession.