Dividend payment decisions are delicate matters. A company’s board of directors bears ultimate responsibility for them, and directors can be individually and collectively held liable if they get the decision wrong.

The stakes are high: excessive dividend payments can lead to credit rating downgrades, increased cost of debt, breaching of debt covenants and a share price collapse when investors realize that dividends are unsustainable.

Company boards don’t always get it right. But the natural discipline that accompanies dividend pronouncements provides genuine insight into the company’s actual performance. Focusing on dividends is also  rewarding to investors:  dividend-paying stocks have outperformed the broader market by almost 2% per year over the long run.

Dividend Decision Time

Companies aren’t obliged to pay a dividend, but when they do, they have to keep their fiduciary duties and statutory obligations in mind.

Fiduciary duties imply that the board consider the well-being of all company stakeholders, while Canadian statutory obligations specifically require that directors must believe that the dividend payment is not going to jeopardize the ability of the company to meet its ongoing financial obligations. To satisfy these requirements, the directors need to review the company’s financial statements and receive confirmation from the chief financial officer or external experts that the company will be able to meet its future debt repayments, capital expenditures and other financial commitments.

Directors also know that rating agencies and debt holders keep a close eye on the impact of dividend payments on the company’s financial standing. Dividend payments that reduce the ability of a company to service its debt will disappoint the ratings agencies and debt holders – potentially leading to ratings downgrades, an increase in the cost of debt, or even a breach of debt covenants.

Another factor that directors consider is a possible collapse of the company’s share price if dividend payments become unsustainable and have to be reduced or abandoned in the future.

The Dividend Message

For all these reasons, directors are acutely aware of getting the dividend payment decision right. The decision to pay or raise a dividend implies that the directors have considered the current financial condition and performance of the business and all future obligations and commitments.

This is a key reason that we focus much of our time on the analysis of dividend payments. The information contained in the dividend decision is, in our opinion, much more important than the marketing-style pronouncements by company managements that accompany quarterly financial reports.

Some investors would argue that they do not wish to receive taxable dividends from the companies in which they invest. Instead, they would prefer companies to invest excess capital in growth projects, hoping for a better overall return over time. But this preference seems to be flawed, as evidenced by the superior returns of dividend-paying stocks.