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Stepan Lavrouk
Stepan Lavrouk
Articles (48) 

Using Dividends as Signals

How Bruce Berkowitz uses dividends to evaluate company management

January 23, 2019 | About:

In an earlier piece, we explored what free cash flow really is, and looked at Bruce Berkowitz (Trades, Portfolio)’s advice for calculating it in the real world. Today, let's dive into what Berkowitz has to say about using dividends as signals of broader company value.

Recall that dividends are paid out of free cash flow, which is why free cash flow is especially important for dividend investors. However, value investors who are not focused on payouts can also use dividends to evaluate prospective plays.

How are dividend levels determined?

In his introductory essay to a section of Graham and Dodd’s "Security Analysis" on dividends, Bruce Berkowitz (Trades, Portfolio) explained how boards approach dividend payouts:

“Traditionally, corporate boards have tended to set dividend payouts at levels that are comfortably covered by earnings. That way, a greater share of earnings is retained in good times. In bad times, dividends are often maintained even if they exceed free cash flow. A board might do that to express its long-term confidence in the business. If earnings are growing, a board will steadily increase the dividends, though usually at a slower pace than earnings.”

This point highlights the delicate line that management must tread between keeping investor confidence high on the one hand, and on the other hand making sure that there is enough cash reinvested into the business to make sure that it stays afloat during the bad times. On the face of it, this seems banal; however, it becomes more interesting when we consider the different ways in which investors react to dividend policy changes:

“Now, investors scrutinize companies’ dividend policies as a window into management’s thinking about the durability of the free cash flow. If changes in cash flow were considered temporary, companies presumably would not adjust dividends. If management believed the changes were likely to be permanent, it would adjust dividends accordingly. If management regarded new investment opportunities as relatively low risk, those opportunities could be financed with debt, allowing dividends to remain untouched. If new opportunities were viewed as relatively risky, they might have to be financed through a reduction in the dividend. If these strategies were honestly executed, they would help investors extrapolate from current to likely future cash flow and hence, to equity value. In this context, a high dividend level would be a positive factor in equity valuation”.

A game of cat and mouse

So changes in the dividend level should in theory convey valuable information to investors. An increase in the dividend should signal confidence in the size of the future free cash flow. An unchanged dividend in times of adversity should signal confidence in the ability of the company to weather the storm with little or no issues. Seems simple, right? The problem is that companies do not always honestly execute changes in dividend policy and will maintain current levels, even when financial sense would dictate that it should be cut:

“The danger here is that management may be tempted to manipulate the dividend to create an inappropriately favorable picture of future cash flow. Companies under stress, such as General Motors (NYSE:GM) or Citigroup (NYSE:C) [author’s note: this essay was published in 2009] have been, are almost always late to cut their dividends. In such cases investors who buy stocks with unusually high dividend yields and deteriorating fundamentals are asking for trouble. These dividends are likely to be sliced. Companies that pay dividends with the proceeds of newly issued equity rather than free cash flow are similarly likely to be manipulating investors through false signals. Real estate investment trusts and income trusts, which must pay out virtually all their income to shareholders, are similarly reluctant to reduce their stated distributions. On the other hand, companies that have free cash to distribute and poor investment prospects should make higher dividend payouts.”


What initially seems like a fairly obvious discussion on how a change in cash flow affects a change in dividend payout ends up being a fascinating look into the game played between management and investors. Investors use dividends to reach conclusions about the value of a company, so management will sometimes manipulate dividends. This in turn can cause investors to lose confidence in the company, which is why boards need to be careful in employing this tactic.

So the next time you are looking at an income stock, ask yourself two questions: "What does this dividend tell me about the financial strength of the company?" and "What other reasons could management have for setting this dividend?"

Disclaimer: The author owns no stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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