A popular but somewhat complicated concept is dividend investing. Too often, investors chase dividends for the mere fact they have a high yield, and they forget there is an actual company behind that dividend. This can be a portfolio killer. It is usually something more novice investors tend to do. It is similar to trying to time the market. It rarely works out well for the investor. I will give you the reasons why this is dangerous and some things you can do instead of chasing high yield dividends.
The first thing to keep in mind is that if a company has a high yield dividend, it may be a warning sign. It could be okay, but you need to consider why the dividend yield is so high and “appealing.”
When hunting for dividends, here are four key considerations you should assess with every company:
- Excessively High Yield
- Excessive Company Debt
- Dividends to Earning Ratio
- Fundamental Business Concerns
Let’s break each of those down to give you more information, so you can make an intelligent decision about your investments.
Excessively High Yield: Companies that have extremely or excessively high yields often are red flags. This is probably a dividend trap; one that I would recommend staying away from until you have looked at all of the other factors and have really done your research. There are some legitimate stocks that pay high yields around two to five percent sustainability, but those with 12 percent yield should raise some questions.
The following is a list of stocks and their dividend yields that you may want to consider:
- Home Depot ($HD) – 2.51% with a Year to Date of 25.83% – This American company is noted as being the largest home improvement retailer in the country.
- Altria Group, Inc. ($MO) – 6.59% – This is an American company that is one of the leading producers and marketers of tobacco and tobacco related products.
- Procter & Gamble Co. -($PG) – 2.49% – This American company is a multinational company that produces consumer goods.
- AbbVie Inc. ($ABBV) – 3.71% – This biopharmaceutical company is an American company that is a spin-off of Abbott Laboratories.
You can find more information about quality dividend paying stocks from the Dividend Aristocrats list at: https://dividendvaluebuilder.com/dividend-aristocrats-list/ or the Dividend King list.
Excessive Company Debt: Dividends come from the profits of a company and are at the discretion of the company management. Things that can impact dividends are company debt and the economy. Some things to keep in mind are the debt-to-equity ratio and the current ratio. Quite simply they are as follows:
Debt-to-equity formula: This is the total liabilities divided by the shareholder’s equity. The ratio to target is anything lower than 1.0 for a good debt-to-equity ratio. Ratios of 2.0 or higher are considered risky.
Current ratio: When I talk about the current ratio, I am thinking in terms of the current assets divided by the current liabilities. Anything greater than 1.5 or higher is considered a good ratio. A ratio below 1 could indicate that the company may not be able to meet their short term obligations. On the other hand, too high of a current ratio could indicate several things including that the company is not using its current assets effectively, securing proper financing, or properly managing their working capital. You will want to be diligent about looking at these ratios in conjunction with previous periods and juxtapose those figures with other companies from similar industries.
Dividends to Earnings: The payout ratio is my favorite metric for dividend investing. This enables an investor to understand the sustainability of the company’s dividend.
Annual dividend payout ratio to earnings formula: In general, you will want to use the following percentages within the context of the company’s performance.
Good: 0% to 35%
Healthy: 35% to 55%
High: 55% to 75%
Very High: 75% to 95%
Unsustainable: over 95%
Traditionally, the healthy range is the most favorable to see as this is the sweet spot where companies tend to see the most sustainability long term. They are able to reward investors while also not leveraging all of their profits to do so. However, every company is at a different stage of growth, and that may certainly impact this number.
Fundamental Business Concerns: This is fundamentally a timely situation and assessment. However, there are a few things you will need to keep in mind in order to make sound decisions.
Stock Price Movement: It is prudent to check the stock price performance for the last couple of years. The stock price is the denominator and the key in determining the value of the purchase of the individual stock. If the high dividend yield is a result of a rapid drop in the stock’s price, you need to fully understand the reasons behind it.
Cash Flow Statement: Earnings can be deceiving and difficult to deconstruct because things such as one-time accounting items can come into play. I have been behind the scenes as a CPA auditing companies, so I understand how this can be complicated. That is why it is imperative to compare it to the Cash Flow Statement. This statement provides the real picture and is sometimes more useful in evaluating stocks and dividends than simply looking at the earnings as noted on the Income Statement. Further, pay attention if there is a decline in earnings or even if you notice a slowing growth in earnings.
All of this information is available by using the financial statements which include the Balance Sheet, Income Statement, and Cash Flow Statement that you will find in the 10-K/10-Q. You can obtain this information for public companies by checking out that Company’s Investor Relations page or by going to http://sec.gov.
The last caveat is to understand what type of investor you are and to understand your comfort level with investing. If you are one who is a dividend investor, you need to hone in on all of the nuances associated with that. Hopefully, this information will provide you with some of the tools you need to make wise investment decisions.
Note that I receive my dividends via my index funds and am not a Dividend Investor per se, but you can always reach out to me at Budgetdog for help.