Some companies pay regular or one-time dividends as a way of returning cash to their shareholders. Dividends are cash distributions from after-tax net income. The dividend payout ratio is the ratio of dividends per share to net income per share. For example, if a company's net income is $1 per share and it pays an annual dividend of 40 cents per share, its dividend payout ratio is 40 cents divided by $1, or 40 percent. A decrease in the dividend payout ratio has implications for the company and its shareholders.
The dividend payout ratio can decrease for two main reasons. First, companies could reduce annual dividend payments, and second, they could keep dividends constant even when there is an increase in the net income. Continuing with the earlier example, if the company reduces its annual dividend payments to 35 cents per share but its net income stays the same, the new dividend payout ratio is 35 cents divided by $1, or 35 percent. However, if the company maintains its 40-cent dividend but generates earnings of $1.20 per share, the dividend payout ratio would decrease to 40 cents divided by $1.20, or about 33 percent.
A company's dividend payout ratio decreases when it announces a reduction in annual dividend payments. Companies may reduce dividends to conserve cash to reinvest in the company or buy back stock. The market reaction would depend on the circumstances. For example, during the 2008 financial crisis, several small and large companies announced reductions or temporary halts in their dividend payments. The market reaction was muted because investors expected management to conserve cash during a liquidity crisis. However, markets generally tend to punish companies that announce dividend reductions because investors perceive that as a sign of weakening business fundamentals. Investors expect dividend-paying companies to continue or grow their regular cash distributions because many investors depend on dividend income for their living expenses.
Dividend payout ratios also decrease when companies with increasing earnings do not increase their dividend payments at a corresponding rate. Investors generally regard earnings growth positively because it usually means that management is able to grow sales and manage costs. While companies in technology and other growth sectors generally reinvest their surplus cash in operations and strategic acquisitions, investors may pressure the management of companies with large cash balances to increase existing dividends, pay one-time special dividends or buy back stock.
Markets tend to react unfavorably to surprises. Investors expect a clear explanation as to why there is going to be a decrease in the dividend payout ratio. Dividend-paying stocks are an important component of the fixed-income component of many individual and institutional investment portfolios. Company management should keep that in mind when planning a change in dividend policy so that investors can have sufficient time to make the appropriate asset allocation decisions.