What is a dividend and why are companies scrapping it?

Welcome to BUX homeschooling. Learn the basics of investing from hot topics in the news. Lesson 1: What is a dividend and why are companies scrapping it?

Nearly half of all big UK companies have scrapped their dividends since the corona crisis took hold. Barclays, Lloyds, TSB, and a bunch of insurance companies like Aviva are among those doing it. But what exactly is a dividend and why are companies scrapping them?

The dividend is like a bonus

When a company is doing well, it makes a profit. The company then distributes some of that profit to its shareholders. This is called a dividend.

The dividend can be paid out in the form of cold, hard cash (aka the ‘cash dividend’). Alternatively, it can be paid out in shares (aka the ‘stock dividend’).

Not all companies do this and it’s not mandatory at all. But it’s a sign that a company is doing well and the extra income helps attract new investors.

Tech companies are among those that don’t really pay out dividends. Instead, they use every penny of profit to grow bigger and bigger. People invest in these companies because of the potential for price to grow. It’s usually the older, more established names on the stock market that pay out dividends. Particularly in the oil sector, where dividends are kind of sacred because the stock price doesn’t move so much.

BUT… a company can decide to reduce the dividend or cancel it entirely. For example, if they need money for something else. Or if things go wrong, like now, with a global pandemic.

The coronavirus changed everything

The economy has been doing pretty well since 2008, with stock prices rising and money sloshing around the markets. Plenty of companies paid out large dividends to reward shareholders. But those golden times are over.

Now, companies want to hold on to as much cash as possible and guard themselves against uncertainty. In the wake of the coronavirus, a recession is lurking. We’re seeing mass layoffs, shortened working hours, bankruptcies etc. With that in mind, it’s wise to keep some money on the side. Stopping the dividend is one of the first things companies can do to save cash.

Things are a little different for the banks, like Barclays and Lloyds. They are being encouraged by central banks (the Bank of England) to cut their dividend. Why? Because they’ll have more money left over to provide loans, which will help keep the economy ticking over during this tough time.

Still, scrapping the dividend is a controversial move. Investors aren’t exactly happy with the decision. No surprise that a company’s stock price often falls when they decide to slash the dividend.

The companies themselves are also under pressure. Sometimes, a company will layoff employees in order to keep paying out a dividend to shareholders. When that happens, you can bet there’s considerable outrage from the public.

Will it ever go back to normal? Of course. A company can always increase or reinstate its dividend. But it’s impossible to say how long it will take before banks, insurers and other companies will do it.

All views, opinions or analysis expressed in articles are that of the author and do not represent the views of BUX. Neither BUX nor the author provide financial advice and these articles should not be construed as such.