Dividend Cuts: Are They Always Bad News?

Thursday, Jun 14 2012 by
3
Dividend Cuts Are They Always Bad News

Investors hate dividend cuts or suspensions and companies fear them. There are few actions that CEOs dread more than cutting dividends, which partly explains why they happen so infrequently. In his classic 1956 study on dividend policy, Lintner interviewed corporate managers and found: "a reluctance (common to all companies) to reduce regular rates once established and a consequent conservatism in raising regular rates".

More recently, a survey in 2005 of payout policies found that 78% of companies are reluctant to make dividend changes that might have to be reversed. As a result, dividends tend to follow a much smoother path than earnings - the variability from 1960 to 2008 of year-to-year changes in dividends was just 5.2%, compared to 14.7% for earnings!

Don't Frighten The Horses!

Given the typical volatility in corporate earnings and cash flows, it might seem surprising that dividends do not follow suit. Wouldn't it be rational for firms to actively reassess how much they should pay in dividends as their prospects change? Surely paying an unsustainable level of dividends is going to be worse for investors in the long term, especially if it leads to a dilutive capital raising.

Managers' reluctance to cut dividends is however understandable when you look at the typical investor response to a dividend cut. This is indiscriminate. Several studies show that investors just dump the stock - in 80% or more of cases, the stock prices of firms that cut dividends drops sharply, at the time of the announcement. Furthermore, research by Michaely, Thaler and Womack found that that stock prices then continue to drift downwards in the weeks after a dividend decrease. And this seems to happen no matter what the stated reasons for the dividend cut. 

Can a Dividend cut ever be good? 

Companies may cut or suspend dividends for several reasons; some clearly have negative implications for future prospects and the value of the firm, whereas others have more positive implications. It may be:

  • A last ditch response to operating problems (declining earnings and losses), i.e. the company has finally run out of other options.
  • A pre-emptive action to increase financial flexiblity and avoid future problems (e.g. by using the cash saved to retire debt).
  • Alternatively, it could simply be because the firm wants to invest more than it expected (e.g. a dramatic improvement in its strategic…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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