Everyone loves dividends, right? Get money by just owning a stock. Seems just peachy. But there are pitfalls to be aware of….
Just Because
But just because a company pays dividends does not automatically make it something you should jump on.
Be Careful
While all dividends seems the same, the are not. They do not always signify stability and reliability.
What To Look For
Firstly, it is important to understand where dividends come from. Dividends normally come from quarterly earnings.
The total amount of quarterly earnings is dividend by the number of shares outstanding. This gives us the Earning Per Share (EPS) value.
If we compare earnings per share with the dividend paid per share, we can see the relationship in terms of a percentage. The lower the percentage the better. This percentage is often called the Dividend Payout Ratio.
How To See This
Overall, it is commonly thought that things are best when dividends per share are 60% or less of the earnings per share.
But Things Vary
Sometimes the dividend payout ratio s very small, and sometimes it is very high. How to look at this?
Some Do, Some Don’t
Some companies have a perpetually high dividend payout ratio. In some industries, the 60% norm does not apply.
Some Pay Dividends And They Collapse
Just because a company pays a dividend, does make it a good long-term investment. Lehman Brothers paid a dividend just before it imploded. Enron paid a dividend. There are many cases of companies paying dividends but still were unable to receover.
Non-Dividend Paying Companies
As we know, some companies do not pay dividends at all, so it is useless to consider them in this context. But in that sense, we could say their dividend payout ratio is 0%.
When Things Are Low
A company that pays very low dividends compared to their quarterly earnings is considered to use most of their earnings for company operations. It usually signifies that there is room for dividend growth.
When Things Are High
When a company pays a significant percentage of its earnings as dividends, it is time to consider what is going on. Firstly, it signifies that less income is available for company operations. This may or may not be something to be concerned with.
What’s Up When Things Are High
When the dividend payout ratio is north of 60%, sometimes even close to 100%, we can see that the funds for company operations is diminished. It is time to take another look at the situation.
What Could Be Going On
Sometimes, when a company has a poor quarter, with reduced earnings, the dividend payout ration shoots up. If the reduced earnings is a temporary event, it is possible that income will recover in a following quarter, so perhaps there will be no long term harm.
What Else Could Be Going On
Sometimes reduced earnings is a sign of significant downward changes in a company’s prospects. As a result, sales and/or earning both decline, which also reflected in a high dividend payout ratio. If management perceives they need to take strong action to increase retained earnings, it is possible that the dividend might be reduced.
When Things Are Sky High
There are times that the dividend payout ratio is over 100%, sometimes even hundreds of percent. These cases may also be temporary, or may be significant and troubling.
Some Are, Some Aren’t
There are companies that will borrow to continue paying dividends. Often they do not wish to sully their reputation as a dividend payer, so they resort to what they can to maintain paying dividends.
In cases where the dividend payout ratio is high, it is prudent to consider what is going on. Are the company’s prospects still good? Are sales declines only temporary or indicative of a long term downward trend?
So Why Do You Say Risky?
The consideration of risky comes from the fact that one might purchase a stock with the expectation of a certain dividend only to have it be reduced or eliminated. While not always avoidable, we’d like to be cautious on the side of prudence.
A Word To The Wise
In the same consideration is the dividend yield itself. A dividend yield that is abnormally high is considered a dangerous sign. See What Are Realistic Dividends?
What is your take on dividends? Comment here: Contact
The photograph of the head of the Sphinx was taken in 1860 by German traveler Wilhelm Hammerschmidt.
The Venezuelan motif was printed as an insert card in Allen & Ginter cigarettes, 1887.
The watch was made by Charles Wilson in Belfast, Ireland, in 1809.
The three illustrations are courtesy the Metropolitan Museum of Art, and are the public domain in the U.S.
The post Dividends Are Not Always a Good Thing. Sometimes They Are Risky. appeared first in Smile If You Dare.