Nothing puts a smile on an investors face like an increase in dividends. Dividends are cash distributions that many companies pay out regularly to shareholders from earnings that send a clear message about future prospects and current performance. Before corporations were required by law to disclose financial information in the 1930s, a company's ability to pay dividends was one of the few signs of its financial health.

Typically, mature, profitable companies pay dividends; however companies that do not pay dividends are not necessarily worthless. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the profits and reinvest them into the business. For these reasons, hardly any growth companies pay dividends.

Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things:

1)       The share price is high because the market reckons the company has impressive prospects.

2)      The company is in trouble and cannot afford to pay reasonable dividends

When you evaluate a company's dividend-paying practices, ask yourself if the company can afford to pay the dividend. The ratio between a company's earnings and net dividend paid to shareholders - known as dividend coverage - remains a well-used tool for measuring whether earnings are sufficient to cover dividend obligations.

The ratio is calculated as earnings per share divided by the dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut, which can have a dire impact on valuation. Investors can feel safe with a coverage ratio of two or three. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under one, the company is using its retained earnings from last year to pay this year's dividend.

At the same time, if the pay-out gets very high, say above five, investors should ask whether management is withholding excess earnings, not paying enough cash to shareholders. Managers who raise their dividends are telling investors that the course of business over the coming 12 months or more will be stable.

If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming. While a history of steady or increasing dividends is certainly reassuring, investors need to be wary of companies that rely on borrowings to finance those payments. Dividends bring more discipline to management's investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets.

Dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share, and it is a staple of the capital asset pricing model which, in turn, is the basis of corporate finance theory. According to the model, a share is worth the sum of all its prospective dividend payments, 'discounted back' to their net present value. As dividends are a form of cash flow to the investor, they are an important reflection of a company's value.

Finally, dividends are public promises. Breaking them is both embarrassing to management and damaging to share prices.

Disclaimer: This article was issued by Steve Diacono, for Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.