A:

Although a dividend reduction is generally viewed as a signal to sell, the decision is not as clear-cut as if the dividend were to be eliminated altogether, which would be an unequivocal sell signal. Every manager and board member is aware of the adverse market reaction that is inevitably triggered by news of a dividend cut. So management is unlikely to take this drastic step unless the company's financial situation is challenging enough to warrant such a move.

A dividend increase signals management's confidence in the company's future prospects and its ability to generate enough cash to cover the higher dividend payments with a margin of safety. By extension, therefore, a dividend reduction indicates financial stress and management's lack of confidence in the company's cash-generating ability. In many cases, a dividend reduction may be the first of a series of cuts if the company is unable to address its operational issues and turn things around, or if rectifying these problems takes longer than expected.

However, as outlined below, there may be certain circumstances under which an investor should refrain from pushing the "sell" button after a company announces a dividend cut, tempting though the prospect may be.

If there are extraneous reasons for the dividend cut other than poor operating performance: A company may sometimes reduce its dividend if it has made a large acquisition or needs to conserve cash for a massive project that is incurring cost overruns. In such a case, the long-term benefits from acquisition synergies or project cash inflows may be significantly higher than the short-term losses endured by continuing to hold the stock.

  • If the dividend cut is the result of systemic financial stress (causing a wide-ranging correction across multiple markets and asset classes): A company with a stellar track record of dividend payments may be forced by market conditions to temporarily reduce its payout or eliminate it altogether. The number of dividend reductions and eliminations reached a multiyear high during the global credit crisis and recession of 2008 to 2009. But many of these companies reinstated dividend payments in subsequent years as their fortunes improved in line with the upturn in the global economy, and their stocks rebounded substantially as a result. Jettisoning a quality stock that has slashed its dividend because of tough but temporary economic times may prove to be a classic case of selling low and buying high.
  • If market reaction to a dividend cut is too extreme: If a stock plunges disproportionately as a result of a dividend cut, its yield may still be appealing enough to attract yield-oriented investors with a higher tolerance for risk. For example, consider a $20 stock with an annual payout of $1 (for a dividend yield of 5%) that cuts its dividend by 20% to 80 cents. If the stock plummets by 25% to $15, the dividend yield - despite the lower dollar amount of the payout - would actually be higher, at 5.33%. Even if the stock only falls 10% to $18, the revised dividend yield of 4.44% may be sufficient to attract investors.
  • If the magnitude of the dividend cut is less than anticipated: Dividend reductions generally do not come as a surprise, since management may telegraph its intentions to conserve cash well in advance of the actual cut. In some instances, if the magnitude of the dividend cut is less than what investors had been bracing themselves for, the stock may sell off only modestly. It may even rally in rare instances if investors approve of management's decision and view the cash conservation policy favorably.

In summary, while a dividend cut may generally be viewed as a signal to sell, investors should check to see if any of the above mitigating circumstances exist before hastily selling the stock.

RELATED FAQS
  1. Why would a company make drastic cuts to its dividend payments?

    A dividend cut occurs when a dividend paying company either completely stops paying out dividends (a worst-case scenario) ... Read Answer >>
  2. Can dividends be paid out monthly?

    Find out if stocks can pay dividends monthly, and learn about the types of companies most likely to do so and how monthly ... Read Answer >>
  3. Which is better a cash dividend or a stock dividend?

    The purpose of dividends is to return wealth back to the shareholders of a company. There are two main types of dividends: ... Read Answer >>
  4. What types of companies offer the most dividends?

    Find out which types of companies tend to offer the most dividends, and learn why dividends must be considered carefully ... Read Answer >>
  5. Do I receive the posted dividend yield every quarter?

    First things first: a company with common stock that pays a dividend will typically distribute the dividend every quarter. ... Read Answer >>
  6. Can I receive dividends on ordinary shares of a company?

    Understand the basics of collecting dividend payments on ordinary shares, including when dividends can be paid and under ... Read Answer >>
Related Articles
  1. Investing

    The 3 Biggest Misconceptions of Dividend Stocks

    To find the best dividend stocks, focus on total return, not yield.
  2. Fundamental Analysis

    Why Dividends Matter

    Seven words that are music to investors' ears? "The dividend check is in the mail."
  3. Investing Basics

    The Risks of Chasing High Dividend Stocks

    Dividend stocks offer enticing yields, but a lot can go wrong on the way to collecting that dividend payout.
  4. Markets

    Due Diligence On Dividends

    Understanding dividends and how they work will help you become a more informed and successful investor.
  5. Investing Basics

    How Dividends Work For Investors

    Find out how a company can put its profits directly into your hands.
  6. Investing Basics

    The Importance of Dividends in Your Portfolio

    Learn some of the primary reasons why dividends constitute a critical factor in the overall performance of a stock investor's portfolio.
  7. Stock Analysis

    5-Star Dividend Stocks

    Stocks that consistently pay sizable dividends offer important advantages to individual investors. Here are five worth a look.
  8. Stock Analysis

    These Companies Have Raised Their Dividends for 50 Consecutive Years

    Imagine if you had bought these stocks 20 years ago. If you had, then right now you'd be earning dividend yields of... 27%... 33%... even as high as 65%. And that's from brand name companies ...
  9. Investing Basics

    Don't Take Dividends For Granted

    Companies have been paying dividends to their shareholders since the 1600s and have given investors good reason to hold onto their shares for long time periods. For many investors, dividends ...
  10. Investing Basics

    What Dividends Say About Stock Health

    Dividend payments may reveal information about the future prospects of a company.
RELATED TERMS
  1. Forward Dividend Yield

    An estimation of a year's dividend expressed as a percentage ...
  2. Accelerated Dividend

    Special dividends paid by a company ahead of an imminent change ...
  3. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends ...
  4. Indicated Dividend

    The total dividends that would be paid on a share of stock throughout ...
  5. Stock Dividend

    A dividend payment made in the form of additional shares, rather ...
  6. Preferred Dividend

    A dividend that is accrued and paid on a company's preferred ...
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center