Why dividends may be bad for health

We all like the prospects of receiving $, which is why stocks that offer a dividend has such an allure to it. But it doesn't always make sense to buy a stock just for the dividend. You will see that later. For now, let me go back to basics 101.

 

Where do dividends come from

Dividends can be paid out from 1) earnings stream and/or 2) assets.

 

To pay more dividends per share, the company can

i) Increase profit,

ii) raise payout ratio (i.e. % of earnings that gets paid out),

iii) pay out of cash on hand,

iv) borrow to pay out to shareholders,

v) reduce share base by repurchasing shares

 

Note that per share is what investors should be interested in. Speak to me here if you don't know why.

 

The dividend yield is simplistically the dividend per share divided by the share price. It essentially shows how much you are paying for that stream of dividend.

 

Why getting a lot of dividends is good

A bird in hand is better than two in the bush. Getting a dividend helps lock in some potential returns. On average, it has been proven that dividends is a significant contributor to total returns for investors.

 

It provides a return while investors wait for good thing to happen. It allows for patience, which is an investor's greatest asset.

 

Why getting a lot of dividends is not always a good deal

Lower growth. There is a trade off between growth and dividends. The more the company pays out, the less it retains to grow the coy. That means potentially lower growth. And we want growth because higher earnings often means higher dividends too! By getting more now, you may actually end up getting less in total over the long term.

 

The dividend may not be sustainable. If the company is paying out too much of its earnings or borrowing to pay out dividends, there is a risk that the company is under-investing in its business or spending beyond their means (like how it is bad to borrow from loansharks to spend). In such instance, the dividends may not be sustainable.

 

The same can be said for companies whose future profitability is in question - e.g. manufacturers of tape recorders - and consequently whose dividends cannot be maintained at current levels.

 

It is important to monitor the cashflows to make sure there is enough cash coming in to pay cash to you.

 

How much should you pay for dividends

No rules..There's no hard and fast rule here. It depends on the specific industry the company is in and the specific company itself. Broadly speaking, you can price it on an absolute basis, or on a relative basis against peers or against historical valuations. If you don't understand this terms, speak to me here.

 

Except the rule of total returns...The only rule is that you should not overpay for dividends alone. You must factor in the prospects for growth or lack of. You need to measure the prospects of capital gain or loss against the dividend yield you are receiving. Look from the perspective of total return. [total return = dividend + capital gains]

 

The ideal company

Put simplistically, the ideal company is one which

i) pays a decent dividend yield,

ii) do so at a manageable payout ratio to balance paying a dividend and growth,

iii) has demonstrated this by increasing dividends across time

iv) can sustain the dividends going forward

v) and provide prospects for capital gains as well

 

Where can you find a dividend winner

i) Read this blog (subscribe to it via the box on the top right hand side),

ii) Join my course,

iii) Read the papers/magazines (Straits Times/Business Times/Edge)

----
http://value.i3-institute.com
http://www.facebook.com/i.invest.institute