Dividends

Dividends are usually a portion of the earnings per share. Therefore, let us look at the limits first, a dividend of zero and a dividend greater than the EPS.

When management doesn’t pay a dividend, it is saying, “Let’s keep the profits. We will invest it at a high return, and we will leverage it to against additional new debt. The company will get bigger and better at producing future earnings.” This makes sense to investors, but it is not quite the same as having cold hard cash placed in an investor’s palm. If management is correct, EPS will go up in the future, and the stock price will rise. However, if dividends fall, stockholders must consider the possibility that management will do worse with the money than the stockholder, and stock price will fall.

Above the EPS, management is extracting excess equity and giving it stockholders. This may be appropriate, but it cannot be sustained. Eventually all of the equity would be paid out. Therefore, a stockholder does not reward the company with a higher stock price.