A portion of a company's net profits can be allocated to shareholders as a dividend, or kept within the company as retained earnings. Dividend payments are decided by the board of directors and must be approved by shareholders. These payments can be issued as cash or as shares of stock.
A dividend cut occurs when a dividend-paying company either completely stops paying out dividends (usually a worst-case scenario) or reduces the amount it pays out. This most often leads to a sharp decline in the company's stock price, because this action is usually a sign of a company's weakening financial position, which makes the company less attractive to investors.
- Dividend cuts are most often a negative sign for a company's financial health.
- Companies usually make drastic dividend cuts because of financial challenges like declining earnings or mounting debts.
- Sometimes companies may cut dividend payments for more positive reasons, like preparing for a major acquisition or a stock buyback.
Understanding Why Dividends May Be Drastically Cut
Most Often Bad News
Dividends are usually cut due to factors such as weakening earnings or limited funds available to meet the dividend payment. Typically, dividends are paid out from the company's earnings, and if earnings decline over time, the company either needs to increase its payout rate or access capital from other places, such as its short-term investments or debt, to meet the past dividend levels.
If the company uses money from non-earnings sources or takes up too much of the earnings, it may be putting itself into a compromising financial position. For example, if it has no money to pay off its debts because it is paying out too much in dividends, the company could default on its debts. But usually, it won't come to this, as dividends are usually near the top of the list of things cut when the company is faced with financial challenges.
This is exactly why dividend cuts are seen as a negative. A cut is a sign that the company is no longer able to pay out the same amount of dividends as it did before without creating further financial difficulties.
Not Always Bad News
While most investors rightly consider a drastic dividend cut a negative sign for a company's health, on some occasions, it is not such a harbinger of doom for a company.
Under certain conditions—for example, when the pricing and conditions are just right for a stock buyback; weathering a major recession becomes the priority; or a company needs to accumulate cash on hand for a big merger or acquisition.
In these cases, a dividend cut—even a rather drastic one—may not necessarily be a sign of trouble, or even a sign that selling the stock is your best course of action. Like with any and all financial decisions, doing due diligence and careful research is key to successful investing.
The Bottom Line
Companies that can grow their dividends are seen as stable and attract investors looking for income as well as capital gains. Sometimes, however, it can hurt a company's bottom line to distribute profits as dividends rather than retain earnings to solidify the company's financials. Companies may cut dividends in response to an economic downturn, a spate of negative earnings, or more serious threats to the company's health. Other times, the cut may be more strategic and orient towards future growth or allow for buybacks.