Sunday, July 20, 2008

Dividends Have A Signaling Effect

I recently ran across an article by David Merkel, CFA of The Aleph Blog. The article is titled, Thinking About Dividends.

One portion of the article notes the important aspects of using a dividend growth discipline in evaluating stocks. One of those aspects is the impact on company financial ratios from a company trying to maintain a certain level of dividend or a certain dividend growth rate. Management at dividend oriented firms know investors own the company's stock due to the dividend and its growth rate. Consequently, management and boards attempt to do a great deal to maintain historical dividend practices. As a result, if a company's business prospects are faltering, management may take on more debt to pay a dividend (leverage ratios increase), the dividend payout ratio may be trending higher and cash flow may be declining. These are some red flags that may warn an investor of difficult times ahead for the company and its stock.

David Merkel's article notes:
Dividends have a signaling effect. They teach management teams a number of salutary things:
  • Equity capital has a cash cost.
  • Be prudent risk takers, because we want to raise the dividend if possible, and avoid lowering it, except as a last resort.
  • Focus on free cash flow generation. Be wary of projects that promise amazing returns, but will require continual investment.
  • Be efficient at using capital generated from free cash flow. The dividend forces management teams to do only the most productive capital projects. Increasing the dividend is alternative use of capital that must be considered.
  • Dividends keep management team honest in ways that buybacks don’t. Buybacks can quietly be suspended, but in the American context, a dividend is a commitment.

Now, if you are going to use dividend yields as a part of your strategy, you need to pay attention to two things:

  • Payout ratios, and
  • Growth of the dividend is more important than its size.
The Merkel article contains additional factors surrounding dividend growth investing that makes it a worthwhile read.

Thinking About Dividends
The Aleph Blog
By: David Merkel, CFA
July 20, 2008

No comments :