Why Dividend Rate Cuts Happen – Financials

Over the last six months we have witnessed a staggering number of dividend cuts. To Graham style investors, or pure dividend investors this has come as upsetting news- especially to those who didn’t see it coming. A dividend cut can instantly impact the stock price of a company in addition to your ROI. Why do dividend cuts happen, and how can we learn to see them coming? In the following short series we will introduce some of the main reasons why dividend cuts happen and how you can learn to anticipate them.  Our first topic is the most common reason for dividend cuts so lets get into it.

Reason 1: Severe unforeseen financial circumstances

This is the most obvious reason for a dividend cut but we would be remiss if we didn’t mention it in the series. When a company pays a dividend that comes directly out of the earnings. When the rate of the dividend is set this is based off a prediction, with a margin of safety, of what future earnings will be. If a massive change comes to the expectation of earnings, and that change is likely to continue for a sustained period, a dividend cut is inevitable.

How to See this Scenario Coming

Look at the earnings of the company over a long period of time and monitor the rate of change, if a sudden unexpected change occurs then look at what management are saying.  Is this a bump in the road or is this expected to continue, and how big a bump is this. Lets look at an example to see if we could have predicted the rate cut.

The GM Example

GM cut its dividend completely July 15 2008. What were GM’s earnings like leading up to this period.

How could a company who was experiencing such hard times do anything but cut its dividend in 2006 and then outright cancel it in 2008? Any plan GM had made for itself was based around positive results, there was a buffer for bad times but a $30860M shortfall in income was surely an unforeseen circumstance. Looking back now would you have expected the dividend to continue after reviewing the 2007 financials- no? Good!