Dividend raises put capital back in the hands of investors.  The argument for raising is that the capital returned has more certainty than other uses of capital.  Capital used to repurchase shares should result in a higher stock price, but that is not guaranteed.  Capital used to pay down debt should strengthen the balance sheet and result in lower financing costs, but that is not guaranteed.  Capital invested in new growth projects should result in future earnings growth, but that is not guaranteed.

Higher yields will help the stock price.  Many investors, especially high-yield investors, compare securities by yield shopping.  A stock’s yield, for example, will be compared against treasury bond yields, taking into consideration differing risk levels.  If a company raises its dividend, the yield goes up unless the stock price goes up by the same amount.  A higher yield, the argument goes, will attract new investors, which will raise the stock price.

Dividend raises are a signal that management is positive about the company’s future.  Managements often make the decision to raise their dividends when free cash flow grows.  However, they will do so only if they believe that the higher level of free cash flow is sustainable.  Thus, a dividend increase by management is a signal to the market that management believes improved results will continue forward.  That signal, more than the dividend increase, will result in a higher stock price. 

Dividend increases mean the company faces limited investment opportunities.  The Gordon stock valuation model assumes that a stock’s price is based on an assumed rate of return on investment.  If management chooses to return capital to shareholders (either through a dividend or share repurchase), it is determining that the return to shareholders is higher than any other return it can get with the capital.  This may be a signal of slowing growth as management opts to forego investing in new plant and equipment or moving into new products or business territories.

Dividend increases may mean management thinks the stock price is overvalued.  If management thinks a stock is undervalued, it will most likely use excess capital to repurchase the undervalued stock.  By using the capital to increase the dividend instead of repurchasing shares, management is signaling that it thinks the stock may be fully priced or overvalued.

The market penalizes dividend cuts more than it rewards dividend increases.  It is well documented that dividend increases are correlated with stock price increases (contradicting Miller and Modigliani’s 1961 “Dividend Irrelevance” claims).  It is also documented that dividend cuts are associated with a drop in a company’s stock price, and that there is a higher correlation between changes in dividend levels and changes in a stock’s price when the dividend is cut.  Investor’s trust of management takes a long time to build up but a short time to be destroyed.  Dividend increases take away some of the cushion management has to deal with a decline in earnings.

Dividend income is taxed at a higher rate than capital gains tax.  Dividend income is taxed as ordinary income.  Long-term capital gains under the 2018 tax law is taxed at 0%, 15% and 20% depending on one’s income.  These rates are below ordinary income tax rates.  As such, there are tax benefits to receiving reinvested capital in the form of future stock price increases versus dividend income, all other things being equal.

Dividend increases weaken the company’s balance sheet.  Dividends represent a removal of capital from a company’s balance sheet and thus a weaker balance sheet.  If the capital is used to pay down debt, there is an automatic strengthening of the company’s balance sheet.  If management choose to invest the capital, it will be removed through higher capital expenditures.  However, the capital is expected to be returned to the company’s balance sheet in the form of higher earnings and cash flow at a later date.

Raising dividends on a regular basis is probably a sign of improving company fundamentals.  Investors should not, however, automatically view a dividend increase as a positive event.  Dividend levels should be viewed alongside company fundamentals when assessing what the increase means.  A dividend increase, combined with an increase in share repurchase, the retirement of debt, or an increase in capital expenditures is probably a good indication of an improved company outlook. 

Sources:

https://www.fool.com/investing/dividends-income/2010/07/02/why-big-dividends-are-bad-news.aspx, Dan Caplinger, The Motley Fool, April 6, 2017

http://people.stern.nyu.edu/adamodar/pdfiles/acf4E/webcastslides/session25.pdf, Stern, NYU lecture

https://pdfs.semanticscholar.org/8b45/6c5423070171d5bb0447800390ab0c147299.pdf, Elisabete Vieira, Universidade de Aveiro