Dividends Part Deux

I have written about dividends previously, but since there has been such discussion regarding dividends in the financial media lately I felt it is definitely worth revisiting the subject. Dividends and high yielding debt securities (also known as junk bonds) have become the newest “hot” investment over the last several years in the face of low-interest rates and depressed economic growth. With the onslaught of “taper talk,” however, and the impact that it is having on domestic securities and emerging markets, this trend towards simply buying everything yielding over 3% has slowed. Many high yielding dividend stocks and bonds have suffered losses as returns on less risky assets (like U.S. debt securities for example) have risen, but does this mean dividend investing is a bad idea?

Absolutely not!

Like every other investment strategy, to be successful at dividend investing you need to do your homework – simply following the latest “trend” is a surefire recipe to lose your money. There is an abundance of information available to investors with just a few clicks, and most of it is available for free! Let’s review some of the metrics and ratios that can be used to help evaluate whether a particular dividend paying investment is the correct financial move.

Dividend payout ratio – basically this represents how much of a firms net income is paid out to shareholders in the form of dividends. If a firm earned $5/share and paid out $3.00 in dividends, its payout ratio is 60%. Keep in mind that dividends are paid with cash flow not net income, but this is a good place to start.

Retention ratio – if you assume that the retention ratio is (1 – payout ratio) you would be correct! This is the percentage of earnings “retained,” or reinvest in the company. In this case, the retention ratio would be 40%.

Every industry is different, and it is important to compare the firm you are considering with other firms in the same industry: if the industry payout average is 50% and the firm you are interested is pays out 70% of its earnings in dividends this might be cause for concern. On the other hand, if it only pays out 30% that could indicate the firm has room to raise the dividend, which would lucrative for investors holding the stock.

One more thing to research before investing in a high yielding stock – how is the firm funding these dividends? Due to record low rates many corporations have been issuing large amounts of debt since the recession, in order to pay substantial dividends without having to repatriate overseas cash, but is issuing debt to pay dividends really a sustainable business strategy?

Food for thought.

Happy Reading!

http://www.investopedia.com/articles/investing/082613/lessons-corporate-dividend-payout-and-retention-ratio.asp

http://www.investopedia.com/university/ratios/cash-flow-indicator/ratio4.asp

http://finance.yahoo.com/news/growing-number-debt-issues-funding-113000648.html

http://www.moneynews.com/InvestingAnalysis/interest-rates-dividend-stocks-Fed/2013/06/05/id/508126

http://articles.washingtonpost.com/2013-08-20/business/41427591_1_bond-funds-bond-market-bond-investors