 Personal Finance PowerPoint Presentation Dividends. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia. Why dividends matter to investors, which you can find online. Take a look at the references, resources, continue your research from there. This by the Investopedia team, updated January 27th, 2021. In prior presentations, we've looked at investment goals, investment strategies, investment tools, keeping the two main categories of investment in mind, fixed income, typically bonds, equity, typically stocks. We're looking on the stocks side of things now as we consider dividends. Let's give a quick recap of corporations, stocks, and dividends in general. A corporation is a separate legal entity breaking their units of ownership out into equal units called stocks. The stocks then, if the corporation goes public, may be offered on exchanges. The exchange is making it easier for the corporation to generate more capital, or in other words, money to help them grow by issuing the stock to more people and then individual investors having the capacity to participate in these investments by purchasing the stocks. Now when we think about dividends, the dividends represent the earnings of the corporation that are being distributed to the owners in the form of the dividends. They're a little bit different than if you're talking about like a public or a private company or a private-life partnership, or let's say a sole proprietorship. If you have a partnership or a sole proprietorship, for example, and you generate revenue, as the owner, you can say, go in and say, I would like money from the revenue that I have generated to live on. You can take out what is called generally draws, taking money out. On the corporate side of things, you might think, well, I am the owner of the corporation with a share of stock. I should be able to go to the corporation and ask them to give me some of the money that I have earned in the form of a draw, or in this case, a dividend. Doesn't work quite that way, because remember, the stocks have to be all the same or uniform in nature, so you can't have some owners getting draws or dividends and others not getting draws or dividends. Therefore, if they declare a dividend's gonna be given, it has to be uniform to all owners. So with regards to the dividends, you've got the owners who have the capacity to vote for the board of directors, possibly oftentimes in a similar way as in a republic. We have the capacity to vote for representatives in a republic, and then in our one individual vote, or our multiple votes, if we have multiple shares in a corporation, may not be a very large percentage of the overall votes, for example. And then of course, the board of directors then hires the management, like the upper management CEOs, they then hire the rest of the employees and so on and manage the company. So the people that we would vote for our representative, the board of directors and management would be the ones to determine if dividends, earnings be distributed to owners, to stockholders. Okay, so one of the simplest ways for companies to communicate financial wellbeing and shareholder value is to say the dividend check is in the mail. So note that when a company is trying to show that they're doing good or they're financially sound, if they have the capacity to give a dividend, that's not only a benefit to us as the owner of the stock in terms of we get cash, but it's also giving a signal from the company that we're feeling strong, that we can give money out and still have the funds necessary to meet the needs that we need to meet. Now again, that signal could be a little bit different depending on the category of stock that we're talking about, like growth stock versus stocks that are, that are like blue chip stocks where they are on their business cycle, for example. But dividends, those cash distributions that many companies pay out regularly from earnings to shareholders send a clear, powerful message about future prospects and performance. So a company's willingness and ability to pay steady dividends over time and its power to increase them provide good clues about the fundamentals. So note that if you're dealing with a company and they decide to give a dividend or they're able to give a dividend for a long period of time, that gives some looks of stability so it might give us some more confidence. If they increase their dividends, that usually is gonna make us feel more confident as well. And normally companies are gonna be cautious or careful to be able to increase their dividends and not wanna pull them back because if they decrease the dividends, that can give us the opposite sign. So usually if they're gonna up the dividends, they're gonna do it in such a way that they signal to the shareholders that they're doing it either for a particular reason or that they can sustain that increased dividends in a way going forward because to decrease the dividends could be of course a negative signal. So dividends signal fundamentals before corporations were required by law to disclose financial information in the 1930s, a company's ability to pay dividends was one of the few signs of financial help. So when you look at the history of stocks, all these developments were really revolutionary, really huge developments. The idea of having a separate legal entity like a corporation, the idea of having exchanges, the idea of being able to trade the stocks and have more individuals involved, huge steps ups, and the 1930s, you don't have as much regulation in terms of the financial statements being prepared in a certain way and therefore signals of financial health such as liquidity, like giving out dividends would be a major signal in that environment. So despite the Securities and Exchange Act of 1934 and the increased transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company's prospects. So cash is king, right? Cash, I mean, if they got the cash flow that's a good indication. So typically mature profitable companies pay dividends. So when you think about the lifespan of a company, if a company goes through their full life cycle, you would expect they'd go through a high growth spurt if you think of say a Microsoft or something. Clearly they go through a high growth spurt which is a great time to own the stock because clearly the value of the stock will go up but you would expect rapidly go up rapidly but you would expect then they would not be paying much dividends out at that point in time because they're reinvesting it in the company in order to grow. And then at some point you would expect once they get to some level, they might be at a secure point such as Microsoft Now so that they might not be putting as much money back into the company to grow at the same kind of rates they were before but they're marching right along and they're quite solid and steady and therefore the revenue that they're getting, they don't need it possibly so much to grow and expand as much and therefore they can give it out in the form of dividends. So you would expect those blue chip stocks, those ones that are marched along have already been constructed and built to be the ones that might be giving out more dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, it often keeps the profits and reinvests them into the business. So if they're thinking for the good of the shareholder, if I'm the shareholder, what would be better for me? Well, if they give me a dividend that's great because I can take that and I can invest it and get a return. But if they can take that money and buy machinery, equipment, factories that are gonna make more money than I could get if I was to get the dividend and invest it elsewhere, then yeah, I would want them to invest the money which would increase the stock price as opposed to getting the money in the form of a dividend. So for this reason, few quote growth companies end quote, pay dividends, but even mature companies while much of their profits may be distributed as dividends still need to retain enough cash to fund business activities and handle contingencies obviously. So dividend example, the progression of Microsoft MSFT through its lifecycle demonstrates the relationship between dividends and growth. While Bill Gates brainchild was a high-flying, growing concern, it paid no dividends but reinvested all earnings to fuel future growth. So when the company was starting out clearly saying, hey, look, I need to reinvest everything right here so that we can keep growing, keep buying what we need to buy, investing in the machinery and so on and so forth. It's gonna be worth your while investors because we're gonna grow like crazy. So eventually this 800-pound software gorilla reached a point where it could no longer grow at the unprecedented rate it had maintained for so long. So if you look at a growth cycle of a successful company that goes through the full growth cycle like Microsoft, you could say, well, they're growing like crazy. There's no way that you can keep the growth rate at that pace forever because you're gonna get to a size in which you're not gonna be able to grow relative to the size at some point. So that's when you're gonna taper off on how rapid the growth will be, which means if you buy the stock at that time, you're not expecting the value to increase at such a huge rate, but you might have a still steady growth and you might have dividends at that point. So instead of rewarding shareholders through capital appreciation, the company began to use dividends and share buybacks as a way of keeping investors interested. The plan was announced in July, 2004, nearly 18 years after the company's IPO initial public offering. The cash distribution plan put nearly $75 billion worth of value into the pockets of investors through a new eight-cent quarterly dividend, a special $3 one-time dividend and a $30 billion share buyback program spanning four years. In 2019, the company is still paying dividends with a yield of 1.32%. The dividend yield, many investors like to watch the dividend yield, which is calculated as the annual dividend income per share. So now we're looking at our ratios again. We're taking the dividends, we're getting out on an annual basis divided by the current share price, how much the market is valuing the company for. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things. Number one, the share price is high because the market reckons the company has impressive prospects and isn't overly worried about company's dividend payments. Or number two, the company is trouble and cannot afford to pay reasonable dividends. So when you do these kind of comparisons, you would be looking at people in the same kind of area. So if you're looking at stocks that are at the tail end of their growth cycle, so they're larger companies, most likely, that are kind of marched along and you're saying, hey, wait, this one company has a much higher dividend yield than the others. That indicating that the other one doesn't feel as secure in their position. If you were to compare to growth stocks, then again, you would expect the growth stocks to not have a big dividend yield because you would expect them to be reinvesting because the reason you're in a growth stock most likely is because you want them valued the stock to go up by them reinvesting the money into the company. So at the same time, however, a company with a high dividend yield might be signaling that it is sick and has a depressed share price. So the dividend yield is of little importance when evaluating growth companies because as we discussed above, retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains, thank Microsoft. So when they're growing, they're not gonna be giving dividends so you can't do the same kind of analysis. When you're talking about mature stocks that are later in their business cycle and you would say they should be just marched along nicely generating revenue, not needing to invest in a lot more new capital and facilities and whatnot because they already have the infrastructure in place. Then if they're not paying dividends relevant to their competition in that area, then that's when you might say, hmm, something looks different. What's going on? Why is that the case? Dividend coverage ratio, when you evaluate a company's dividend paying practices, ask yourself if the company can afford to pay the dividend, the ratio between a company's earnings and the net dividend paid to shareholders knowing as dividend coverage means a well used tool for measuring whether earnings are sufficient to cover different dividend obligations. So you can say are they over stretching, in other words, you know, for their dividend payments. So the ratio is calculated as earnings per share divided by the dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut which can have a dire impact on valuation. So when the company's starting to say, hey, look, things are getting a little thin here between what we can afford to pay out and the dividends we currently have, they might have to cut the dividends and cutting the dividends will have the reverse impact usually as increase in the dividends. They don't want to do that because it's gonna give a negative sign to the market and their share price could be negatively impacted as a consequence. So investors can feel safe with a coverage ratio of two or three generally. So in practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5 at which point prospects start to look risky. If the ratio is under one, the company is using retained earnings from last year to pace this year's dividends. So in other words, you would like the dividends that there be paying out to be representing current earnings. So the current earnings in the current year, you would like the dividends to be coming from there. Now, they could give dividends equal to their retained earnings. The retained earnings represents current earnings and prior year's earnings. But if they're giving out dividends that are higher than their current year earnings, then they can't sustain that forever, obviously, unless something changes, whether that be earnings increasing or they reduce their dividends, right? So they might have a down year, for example, where their earnings are low and they might still give their dividend out that would be over their earnings. And that would mean they're dipping into the prior year earnings. And that might be okay if it was some kind of shock that we all know in the system, we could say, okay, like COVID happened and that was a big hit on this particular industry and we expect them to bounce back. And it's nice that they kept their dividends up in that time. But it would be a bad indication if that was happening with no explanation or normal times. So at the same time, if the payout gets very high, say above five, investors should ask whether management is withholding excess earnings and not paying enough cash to shareholders. So on the other side, on the flip side, you might be saying, hey, look, I'm the shareholder here. You've got these massive amount of earnings that you have, you're already established. You're not putting the earnings back into the company. You're not building and growing like you were as a growth stock, but you're also not giving the dividends out. Why is that the case? Because you've got the cash. I mean, either you should be putting that money to work to make me money as the shareholder or you should be giving it to me as the shareholder so I can invest it. So you can see a situation of them holding on the cash. If they're holding on the cash for no reason, they're not investing it, they're not giving value, then you would expect them to give it to the shareholders. So managers who raise their dividends are telling investors that the course of business over the coming 12 months or more will be stable. So the dreaded dividend cut, so what if they decrease the dividends? That's a bad sign, typically. If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming. So usually companies are really gonna try not to do that. So if they have to do that, it's not normally a good sign. While a history of steady or increasing dividends is certainly reassuring, investors need to be wary of companies that rely on borrowing to finance those payments. So you gotta think about the leverage, how much, you know, how leveraged is the company because if there is a downturn and they're overly leveraged, too much borrowing, it's gonna be a problem. Take for example, the utility industry which once attracted investors with reliable earnings and fat dividends. So as some of these companies were diverting cash into expansion opportunities while trying to maintain dividend levels, they have to take on great debt levels. So notice that some of these companies can kind of run into a problem because they kind of, at one point, they peaked out on their business cycle. So they're in the position where they've got the infrastructure and they're just marching along and they should be passing out the dividends, but then they want to reinvest and reinvent themselves and get into new industries which would require capital, more money, to reinvest. But it's kind of hard to go back in the cycle and try to act like now your growth stock when you're already in the mature phase. So now they're in the situation where they've got to keep their dividends up because decrease the dividends would look bad, but they're also trying to invest as a growth stock would in some areas. And so those things become a little bit difficult. And so they might deal with that by maybe having to spend off or something like that so that they can have aligned their goals or whatever, but in any case, so watch out for companies with a debt to equity ratio greater than 60%. So higher debt levels often lead to pressure from Wall Street as well as from debt rating agencies that in turn can hamper a company's ability to pay its dividends. So we got the great disciplinarian. Dividends bring more discipline to the management investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management and unproductive use of assets. So notice that as industries kind of move on or get more established, it might be have less competition possibly or something like that. If you think of government entities, they clearly or not for profit entities, it's clear that bloat is kind of more easy to happen in some ways there because you don't have the same kind of competition that hopefully is driving companies to be more lean and mean. As large companies get larger, as they get up on the business cycle, they might have more kind of monopoly power in their particular area. And if there's no pressure, some more pressure can be put on them by saying, hey, you should be giving dividends and so on. If not, you can see the same kind of bloating happen as they start to dominate or have market power in their industry, which would mean stuff like they're not being as lean and mean, they've got their overpaying, their management, they've got too much management in the company and they've got things that they could cut out. So studies show that the more cash a company keeps, the more likely it is that it will overpay acquisitions and in turn damage shareholder value. So obviously, if they're being sloppy with their money, then it's not being invested properly. If there was being invested properly to grow, that would be good for shareholders, but if it's not being used efficiently and it's not being paid out in dividends, that would be bad for shareholders. So in fact, companies that pay dividends tend to be more efficient in their use of capital and similar companies that do not pay dividends. Furthermore, companies that pay dividends are less likely to be cooking the books. So let's face it, managers can be awfully creative when it comes to making earnings look good. So note that there's a lot of pressure when you've got these publicly traded companies that are trying to keep the stock prices up and so on to have this nice look of nice increasing earnings over time, which there's audits and stuff to make sure that the books are transparent and whatnot, but there's incentives for management to possibly do things that are not as transparent. So if they're out, but you can't really get away from if you're actually paying cash, just like the good old days, like just like the 30s when the dividends are a cash flow. So that's not something that you can kind of fudge or anything like that. So it could be a good solid indicator. But with dividends obligations to meet twice a year, manipulation becomes that much more challenging. Finally, dividends are public promises. Breaking them is both embarrassing and management and damaging to share prices. So to tarry over raising dividends, nevermind suspending them is seen as a confession of failure. So a way to calculate value, another reason why dividends matter is dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share. So you can try to value a company, for example, by thinking about what its future cash flows will be. So you can try to think about what the future cash flows will be and then try to discount them back to the current timeframe and that's kind of a valuation method. So, and it is a staple of the capital asset pricing model, which in turn is the basis of corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, discounted back to their net present value. So you do a time value money, present value calculation. So as dividends are a form of cash flow to the investor, they are an important reflection of a company's value. It is important to note also that stocks with dividends are less likely to reach unsustainable values. Investors have long known that dividends put a ceiling on market declines.