Negatives of Raising Dividends

Raising a dividend comes with added risk.

Investing in dividend-paying stocks provides an extra layer of security for investors, as they get to collect a dividend while waiting for the price of their investment to rise. Investors also like when a company raises dividends because it shows management's confidence in the company and the strength of its cash flows. However, raising a dividend is not without risk and other potentially negative consequences: It could lead to a company's having to pass up new growth opportunities or acquisitions, bigger cash obligations and less of a cushion if business turns south.

Dividends

There are two kinds of dividends: special and regular. Special dividends are dividends that companies announce after they have had a big cash windfall. Regular dividends are dividends companies pay on a quarterly, semiannual or annual basis. Companies raise dividends for many reasons, and doing so usually has a positive effect on stock price. The reasons they raise dividends are many, but the most common one is that their businesses are generating a lot of cash. They don't have any good growth opportunities with that cash so they return it to shareholders.

Cash Flow Requirements

The first negative of raising a dividend is that now the company has bigger cash obligations. The company has to pay out a certain cash amount each quarter to investors, whether it had a good quarter or not. If the company had a good quarter, then it is easy to meet these obligations. However, if the company had a bad quarter, it may have to dip into its cash reserves or its credit line to cover the dividend payments.

Internal Opportunities

After a company raises its dividends, it will have less cash available. This may be a deterrent to the company if a good growth opportunity appears or a good acquisition prospect. Especially if credit gets tight, a company may have to pass up an acquisition if it only has half of the necessary cash to pursue it. Having raised its dividends also could be a negative if business begins to deteriorate and the company has less of a cash cushion in time of need.

Higher Expectations

After a company raises its dividend, shareholders start expecting that dividend and incorporate it into their forecasts. The company then has additional responsibilities to shareholders; if the company isn't able to pay a full amount or has to cut its dividend because times are tough, the stock will take a big hit as will confidence in the company.

References

• "Harvard"; Why Do Companies Pay Dividends?; Martin Feldstein and Jerry Green; 1983