This article explores why higher dividend expectations are a good bet for higher stock prices.
A dividend is a part of earnings of a company that is distributed to shareholders in a given financial year. Some companies declare increasing dividends every few years, while others are new to issuing dividends, and still some other companies have been issuing constant dividends for a long period of time. What do increasing dividends mean to shareholders? How does the stock market react to the report of increasing dividends? Can expectations of higher dividend be used to make investment decisions?
Importance of Dividends
Higher dividends mean higher returns to shareholders. Since in most countries dividends are taxed at favorable rates, it provides a better net return than interest income. They are also cushions against falling share prices during economic downturn, especially if the stocks are high dividend yielding stocks or defensive stocks. Dividends are real cash. They reaffirm the faith in the financial statements of the company (net earnings can easily be manipulated by aggressive accounting policies and changing accounting choices) and confirm that cash flow from operations are positive and sufficient.
Dividends and Stock Prices
Prices of the company shares end up higher and remain so for a long term after higher dividends are announced. Take the example of Canadian consumer staple retailers like Saputo Inc, Loblaw Companies Ltd and Maple Leaf Foods Inc. Before initiation of the quarterly dividend of 5 cents per share, the shares of Saputo Inc traded mostly below $15 per share. But with initiation of the quarterly dividend in August 2003 and consistently increasing dividends every year, the company shares traded at increasing prices. When the dividend was increased to $0.12 per share, the stock price rarely traded below $20.00. Similarly, further increase in dividend and higher stock prices were positively correlated.
Similar positive correlation could be found with Loblaw Companies Ltd initiating dividends in September 2003 and increasing the dividends up to March 2005. Loblaw Companies Ltd stock price increased from $55.72 in September 2003 to $67.77 on April 1, 2005. However, when the company stopped increasing dividends since April 2005, the stock price consistently declined to $29.99 on Jan 2, 2008 though the overall stock market performed well. Similarly, the stock price of Maple Leaf Foods Inc consistently rose for few quarters after dividends were initiated in September 2003. But with no increases in dividends at a later date, the stock price declined.
Dividends and Stock Selection
Clearly, expectations of increasing dividends can be used to purchase stocks. Also, if dividend announcements exceed analyst expectations, it could be the right time to purchase stocks. However, expectations of higher dividends alone cannot be the deciding factor. If the stock price is already overvalued, lower economic growth rate, economic recession or other factors particular to that company or industry could affect the stock price negatively.
