Dividends are the payouts to shareholders made by companies as a reward for buying stock in that company. Though rarely amounting to anything like 100% of profits, dividends are the cash income reason for many to invest. There are a number of theories regarding the best policy for a company to follow with dividends. Theoretically the amount of a dividend payout is irrelevant to most investors, cashflow analysis shows that the investor should be equally happy with either approach, as retained profits are reinvested back in the company to finance growth and raise the share price.

A policy of paying out almost all profits in dividends tends to stifle capital growth in the share as the company has little retained earnings and less capital available for financing growth and acquisitions. On the other hand the profit of the dividend itself is the reward to shareholders. This argument has been going on for years in academic circles and tends to settle on the conclusion that dividend policy is essentially irrelevant to shareholder returns.

The market, however, sees things differently. Dividend policy is very important to many shareholders, and a steady, reliable and gradually increasing dividend is taken by the market to mean the company itself is steady, reliable and growing. Companies that announce a reduction in the dividend without a satisfactory reason (which might involve cashing up for acquisitions) are frequently mauled by the market. Even companies that announce a shrinking profit may not suffer greatly if at the same time they announce that the dividend will remain unchanged or greater than last year. A steady dividend is valued by the market as a show of confidence by management that profits are secure in the long term. An announcement of a dividend cut is often a sign that management has lost confidence in a rapid recovery or further expansion, and is taking emergency measures to ensure its own longevity. Skittish investors will bail out when such an announcement is made taking their money elsewhere.