Ever seen a high yielding dividend stock but avoided it because you did not know if the dividend was safe or sustainable? This article lists a few steps you can take to help determine just that.
Ok, first all you need a stock right? (yes, you do!). Once you find the stock (and dividend) you want, then the digging starts.
The difference between profit and loss can lie on determining if a dividend can be paid out
A mistake too many investors, specially beginners seem to make is that they do little or even no research whatsoever on their own investments!!! If you do that, then while you could win some money, the most likely outcome is loss of capital or mediocre results.
Many investors ask me at what level should they doubt a stock’ s yield. 20%? 30%? 50%? The answer is that you should always doubt ANY yield. Always know if what you think you are investing in is really what you are getting. A 2% yield could be riskier than a 10% one. A yield’ s size by itself does not mean the yield is safe or unsafe.
Determining a yield’ s safety is in many ways similar to determining a bond’ s safety. Both investments should always be made after answering the same basic questions: Will the company or partnership be able to pay you? and How much are they paying?
Then there are other questions that can help, such as:
What were the company’s earnings last time they paid a dividend?
What are those earnings now?
How does the earnings outlook look?
Are there economic factors that will hurt or benefit the business?
What percentage of their earnings do they regularly pay to shareholders? This last question is key and often receives the name “payout ratio”, you should definitively look up this one.
If a company has declining earnings and also has a payout ratio of 90% or 105% then the dividend is highly likely to be cut. The same company could probably be able to still pay its dividend if it had a low payout ratio such as 15% or even 70% or 60%. It depends on whether the reduced earnings will be able to pay the dividend AND also allow the business to have plenty of money for business operations, debt and capital expenditures,investments,etc…
A stock’s earnings history is useful when deciding where to invest
Remember, once you determine that the company COULD EASILY pay its dividend, that does not mean it will, since the board decides what dividend to declare if any.
Something you can do to address this is research the company’s history in respect to paying dividends to shareholders and their specific dividend policy. REIT’s are different, since they have to distribute most of their money from operations.
Also, just because a dividend is likely to be cut does not mean the stock is a bad investment. There are often bargains among high yielding stocks with unstable dividend. If a 40% yield gets cut by half is still a 20% yield and if that gets cut by half again it is a 10% yield! so don’t necessarily avoid stocks with unsafe yields.
Dividends are a great way to compound your money and they can also be used as a source of income.
While you can certainly do more, these basic steps will help you a lot. For other investment related articles check the resourses section.