A dividend is a partial distribution of a company's earnings paid to a class of its shareholders. Dividends are decided by a company's board of directors and can be issued over various timeframes and payout rates as cash payments, shares of stock, or other property.

Net profits earned by a company can be kept within the company as retained earnings and/or allocated to shareholders in the form of a dividend. A company may also choose to use net profits to repurchase its own shares in the open market in a share buyback.

Key Takeaways

  • A dividend is a distribution of some of a company's earnings to certain shareholders.
  • The decision to issue a dividend, as well as the size of the dividend, is determined by a company's board of directors.
  • Public announcements of dividend payouts tend to trigger a corresponding rise or decline in the company's stock price.

What a Dividend Cut Signals

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 unmistakable sell signal. Every corporate executive and board member is aware of the adverse market reaction that is inevitably triggered by news of a dividend cut. Therefore, management is unlikely to take this drastic step unless the company's financial situation is challenging enough to warrant such a move.

On the other hand, 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. This means a dividend reduction would likely indicate financial stress and a lack of confidence from management 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.

While a dividend cut could indicate financial stress for the company, there are circumstances in which that may not be the case, including systemic financial problems across the market, an overreaction on the part of the market to the cut, or a dividend cut that is nonetheless, smaller than had been expected.

When to Hold off From Selling

There may be certain circumstances under which an investor should refrain from pushing the "sell" button after a company announces a dividend cut, as tempting as it might be to react to the news with an exit from your position.

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 multi-year high during the global credit crisis and recession in 2008 and 2009. But many of these companies reinstated dividend payments in subsequent years as their fortunes improved in line with the upturn in the global markets, and their stocks rebounded substantially as a result. Selling 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 the 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 five percent) that cuts its dividend by 20 percent to 80 cents. If the stock plummets by 25 percent to $15, the dividend yield — despite the lower dollar amount of the payout — would actually be higher, at 5.33 percent. Even if the stock only falls ten percent to $18, the revised dividend yield of 4.44 percent may still be sufficient enough 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 certain instances if investors approve of management's decision and view the cash conservation policy favorably.

The Bottom Line

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.