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How Dividend Activity Sends Signals to the Market

By: Elite Legacy Education, December 13, 2017

It may seem intuitive that you want to hold a stock that pays handsome dividends. This way, you are putting more cash back into your pocket, right? However, a company’s decision to pay dividends is strongly interpreted by the market and can affect its valuation. With that said, companies do not take dividend-related changes and decisions lightly.

 

First, let’s recall what a dividend actually is.

 

As you likely already know, a dividend is a payment from a company to its stockholders. Essentially, this dividend payments comes from the company’s cash balance. Ideally it is covered by the corresponding year’s operating cash flows – this suggests a sustainable dividend level for a company. Essentially, a dividend is the stockholders’ share of the profits. Only preferred stockholders are entitled to their dividends regardless of the company’s financial standing. The opposite is true for common shareholders who only receive dividends if the company has the money for it. In the latter case, it does not cumulate as it does with preferred dividends.

 

So what signals can dividend announcements send?

 

Changes to a company’s dividend policy simply do not go unnoticed. In fact, they really shouldn’t go unnoticed when you think about it. First consider that when a change to the dividend level is made, it is typically made with the long-term in mind. Thus, either increases or decreases to current dividend levels have a profound impact on the market’s outlook about a particular company. On top of this, dividend changes are made by internal personnel. Thus, it is thought that these people have greater insight into the company’s standing which is why this type of activity is seen as a signal.

 

This dividend activity can include announcing a dividend, eliminating a dividend, increasing a dividend or decreasing it. Let’s break this into two categories – positive signals and negative ones.

 

Examples of a positive dividend signal.

 

Dividend activities that are favored by the market are either the announcement of a dividend, or the increasing of current dividend levels. Both of these are seen as indicators that the company can afford to pay out more of its earnings to shareholders. This means that they have a steady reserve of cash flow to sit on. Rather than keep the money in its cash reserves, the firm is choosing to pay it back to shareholders. This suggests the company is confident that it won’t need it to run the operations. It is a positive sign that the company can expect sustaining levels of future operating income. Often, you will see the company’s stock price increase in either of these scenarios.

 

Examples of a negative dividend signal.

 

Dividend signals that are bad tend to be either the elimination of a dividend that once existed, or the decreasing of current dividend levels. Both of these are indicators that the company cannot afford to plowback earnings to its shareholders. Although, we shouldn’t always rush to the worst case scenario. It may be that the company has discovered new opportunities that require investment. Although generally, debt would be used in such a case. As such, a company’s stock price tends to decline as the result of either of these cases.

 

Why it’s better to keep your dividends stable.

 

As you can see from the above activity, slight dividend changes can affect a company’s stock price. Even though a dividend raise may increase your stock price, if you announce too high of a dividend and later have to lower it, then your stock price will drop. Companies must be sure that they can support a particular dividend level in order to satisfy the market. Remember, it is a decision that is made with the long-term in mind. Be sure to consider how it is interpreted by the greater market.

 

The bottom line is that you should pay attention to the dividend activities of various companies. With a bit of research and interpretation it can give you a glimpse into the company’s financial standing. And with that, you can level the stock market playing field once you know what the professional traders know. Our Elite Legacy Education instructors will introduce you to the trading strategies that produce potential profit when stock prices are falling, as well as ways to lock in gains, reduce risk, and squeeze extra money out of stocks in your portfolio.

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