There is a long-held belief that a dividends are a sign of a solid company. Granted, there are justifications for this. In order to pay a regular dividend, a company must have established and generate cash flows that have a level of stability and/or predictability.
Institutions’ Policy On Dividends
When a company establishes a dividend policy, the market usually reacts favorably. The reason is that institutions are the largest shareholders, and they prefer dividends. On the counter-side, if a company cuts its dividend (regardless of the reasons), the market reacts negatively in almost every case. The reason is that there is a large sell off by the large institutional shareholders. Institutions have their own investment policies, and usually they need dividend paying stocks. So in order to comply with their own policy, the large holders engage in simultaneous selling following news of a dividend cut. This creates a buyers market for the stock, plunging it downwards due to lower demand on the buy side.
Intelligent Investing & Dividends
You as an intelligent investor do not need a dividend policy like the institutions mentioned above. Chances are, your capital is the size of a flea on an elephant’s butt compared to institutions. Thus, focusing solely on dividend stocks is not always the best alternative. Dividends are also taxed, which further decreases the already small amount you receive. I’m not saying that you should completely ignore stocks if they pay a dividend. Instead, consider it an extra if you’re investing in a fundamentally good business. If the stock you’re investing in is paying a dividend, there are a few things you should look into.
Yield, Payout Ratio And Financing
The dividend yield is the ratio of a firm’s annual dividend compared to it’s share price. Calculated as a percentage, the calculation is as follows:
Usually you don’t need to do the calculation. The dividend yield is often widely published information on the web. All you need to do is google the company name and “dividend yield”. a healthy dividend yield is usually between 1.5% – 3%. Higher than this may raise concerns over its sustainability. Of course, the number is not set in stone, but its a good starting point.
Next, you wan’t to know the dividend payout ratio. It is the total amount (as %) of dividends paid in relation to the net income. Calculated as follows:
To be on the safer side, prefer this ratio to be >50%. You want to the company retain more of the earnings, in case of a rainy day. Again, this rule is not set in stone, but it’s a personal preference.
Finally, you wan’t to make sure that the company has a long history of positive (and preferably growing) operating cash flows. This is ultimately what finances the dividend. A massive red flag is decreasing operating cash flow, increasing debt, and the dividend is still being paid. Financing the dividend through debt is extremely dangerous and detrimental to your investment. Sooner or later the chickens will come home to roost. A good recent example of this is Nokia. I’ve followed the firms financials for quite some time, and have always wondered how they sustain a dividend with erratic and unpredictable cash flows.
Conclusion
Since you are probably working with smaller sums of capital, focus on the underlying business, and how well it allocates capital. An above average business can grow its intrinsic value per share more effectively if it retains earnings and earns high returns on invested capital. This will compound your investment at a much higher rate than collecting dividends ever will. The most famous example of this is Berkshire Hathaway.
When it comes to dividends, what you wan’t to see is a healthy balance sheet, strong operating cash flows, a lower payout ratio and a yield between 1.5-3%.
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-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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