Saturday, June 6, 2009

Why Dividend Rate Cuts Happen

Dividend rate cuts are painful and can send your portfolio into a tailspin. Why do they happen and can we see them coming? In our continuing series on dividend rate cuts we are going to look at stale dividends with these questions in mind.

Stale dividend rates/ earnings

Dividend rates are set by companies with an expectation around the future growth of the company. As the company's profits increase so too should the dividend rate. When you find a company where the dividend has remained fix for an extended period what you have is a stale dividend.

Stale dividends are usually the consequences of stagnated earnings growth. Company's are designed to grow, few businesses cope well with stagnation. Employees expect to be compensated for hard work at an increased rate, equipment needs to be replaced- if a company isn't moving forward they may well be moving backwards which can be very dangerous for dividends.

How to See Stagnation and The Dividend Cut Coming

Look at the company dividend rates, have they been the same for a few years, have the earnings been frozen or slowly decreasing over this same period. Depending on how much buffer was built into the dividend the company could probably sustain this decaying bottom line for a while but for how long?

Lets look at an example of this to better understand.

Example

NSEC cut its dividend rate in January of 2009 from $.23 to $.15. Before that period they had made 9 consecutive payments of $.23 dating back to 2006. The company had been stuck for over 3 years at the same dividend level. This should have thrown up a few flags for investors.

Having picked up those flags we could have tuned in to look at the overall health of the company to look for stagnation.

income-after-taxyrtotal-operating-expenseyrAs the graphics show the company was struggling to bring in sustained revenue. It was simply not growing. For three years it had flat or negative growth while at the same time its operating costs were rising. NSEC could simply not continue pay out its current dividend rate in this condition.

Stale Dividend + No Growth in Income + Growing Expenses = Bad Situation


Hopefully this warning signs will help you understand why cuts happen and how to see them coming before they hit your portfolio.

Other Articles in the Series

Why Dividend Rate Cuts Happen - Financials


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