Dividends help attract investors. They are payments of cash or additional stock that a corporation makes to shareholders. Dividends are paid with corporate earnings. They provide current income to investors and help stabilize the stock price. Common stock dividends are optional and can change over time. A corporation fixes preferred stock dividends at the time it issues the stock.
Corporations pay dividends out of retained earnings -- the accumulated profits of the company. Dividends are normally paid every quarter. The dividend yield is the annual payout divided by the current stock price. Dividends change when stock prices rise and fall. A corporation may also change the size of a dividend. Corporations do not need to change dividend amounts when the common stock price changes. However, a corporation committed to a particular dividend yield will need to increase the payout if the common stock price rises. When a stock price rises because of increased profits, the corporation might decide to boost dividends to “share the wealth” with stockholders, but it’s optional.
The dividends on preferred stock do not change over time. This has the effect of divorcing the value of preferred shares from the growth of the company.Traders price preferred shares based on their dividend yield relative to prevailing interest rates. If interest rates rise, preferred share prices fall and the dividend yield rises, keeping it competitive with higher interest rates. Lower rates boost preferred share prices. A corporation must pay its current preferred dividends in full before distributing any common stock dividends. “Cumulative” preferred shares also require that any missed dividends be paid before common stock dividends may be paid.
Many corporations, especially utilities and food companies, pride themselves on long uninterrupted records of rising dividend payments. Income-oriented investors find such stocks attractive because the dividend yield relative to their purchase price rises over time. The Gordon Dividend Growth Model calculates the value of a stock share as equal to the dividend per share one year hence divided by a growth premium, which is the required rate of return demanded by shareholders minus the dividend growth rate. The model works best for mature companies that have a predictable dividend growth rate. The model indicates that a dividend boost should energize a stock's price.
Corporations and shareholders abhor dividend cuts because they might signal trouble ahead, such as anticipated poor earnings or a cash crunch. However, not all dividend cuts presage misfortune. For example, the board of directors might want to allocate the dividend to a share buyback program or to invest in exciting new technology. A missed interest payment can throw a company into default and bankruptcy, but a cut or missed dividend payment does not result in default. For this reason, when a corporation's board of directors evaluates its response to low cash reserves, it will suspend the dividend rather than default on an interest payment.
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