The Warning Signs and Impact of a Dividend Cut

By Stock Research Pro • May 7th, 2009

For income-oriented investors, dividend-paying stocks can represent a central part of a stock portfolio. Dividend stocks can offer investors great financial flexibility by providing the opportunity to either reinvest the payments or use it as a source of income. For fundamental investors, dividends add creditability to the investment in a company since dividends are derived directly from the operating success of the company.

For these reasons, many investors will seriously reconsider the attractiveness of a company that might be considering a cut or elimination of its dividends. Investors that pay close attention might detect the warning signs that a dividend cut is on the horizon.



Early Warning Signs of a Dividend Cut

Excessive Dividend Yield: The dividend yield is a fast and easy way to compare dividends among companies. While every investor wants to achieve the highest yield possible from their investments, most companies prefer that their dividend yield be in line with historical and industry averages and may consider cutting the dividend to return to that balance.

A String of Dividend Increases is Discontinued: If a company with a recent history of dividend increases brings those increases to a halt, it may be revisiting its overall dividend policy.

A Change in the Company’s Business Conditions: A company in danger of losing it’s competitive advantage or “moat” might consider a dividend cut in an effort to reinvest in itself to improve processes, product offerings or anything else that might enable it to regain its position.

An Excessive Payout Ratio: Because dividends are derived from the company’s earnings, the company will always evaluate the proportion of earnings or “payout ratio” it allocates toward dividend payments. A high or growing ratio can provide a warning to investors.

Diminishing Cash Flow: Examining the company’s changing levels of free cash flow can help investors determine whether the company can continue to service its debts and maintain a dividend. The comparison would be the free cash flow against the cost of debt.


The Impact of a Dividend Cut on Stock Price

While some investors may look at a dividend cut and decide that the company management is simply responding appropriately to changing business conditions, the historical evidence indicates that the stock price is likely to suffer upon news of a dividend cut.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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