Monday, October 31, 2011

Dividend Investing Tips

By Rajiv Hargunani

Whenever the stock market enters a period of heightened volatility & uncertainty, it seems everybody starts talking about investing in dividend stocks. As if the dividend stocks are immune from the corrections of the stock market. The logic behind such recommendations is that the dividend payments will buffer your losses to a certain extent.

Before you go ahead and invest in a company that pays a hefty dividend, please check a few things such as

1. How frequently has the company raised its dividends? Is it annually, every two years? A candidate for your list should have a good track record spanning decades of consistently increasing dividends.
2. An increasing dividend should imply the company is generating higher income as the dividends are paid out of net income. A ratio that defines this relationship is known as the payout ratio. For example, if the company earns $4/share and pays a $1 dividend, then its payout ratio is 25%. Traditionally, fast growing companies choose to re-invest the earnings into future growth instead of paying back the investors. These companies have low-to-zero dividends. An example that comes to mind is Apple. Be on the watch for companies that have a very high payout ratio, say something in excess of 70-80%. That should indicate the company is having a hard time making its distribution payments.
3. Companies that pay good dividends typically have a solid balance sheet. Some basic metrics such as debt-equity ratio should be watched carefully. This ratio measures how much debt is being used to generate growth. A high debt-equity ratio, say in excess of 2, would imply the company is heavily leveraged. On the other hand, a ration of 0.5 would suggest the company has enough equity to handle its debt (liabilities).
4. The company should have a product or service you can easily relate to. You should be able to see them being around for years (if not decades). Most of the large consumer staple names fit this description.
5. Finally, remember the golden rule. High yields imply high risk. If you see a dividend yield north of 8-9% that should automatically make you check the fundamentals of the company before you jump in. 

If you have done your research well, the benefits of investing in companies that pay a solid dividend is many fold. You get to earn income while holding the shares of the company and secondly you get to participate in the growth of the company. If you use the dividends to reinvest (purchase additional shares of the company), those new shares will generate additional dividends in future years. Over time, reinvestments can grow into a large enough assets, that the dividends on that asset base will be good enough to provide a regular income stream.

Dividends are not guaranteed and must be authorized by the company’s board of directors.

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Other posts by Rajiv Hargunani:

• Recovering From Large Investment Losses
• Inflation: What it means & how to protect our investments
• Emotional Investing: How Fear & Greed can impact your bottom line
• Early Distributions From Retirement Plans
• Profit From Your Losses
• A New Approach to Making Money: Buy and “Know when to sell”
• Health Insurance:  Decisions, Decisions
• Common Insurance Mistakes - Are YOU making one?   
• Managing Risk in Volatile Markets
• 2010 Roth IRA Conversion – To do Or Not to Do
• Changing Jobs? Don’t let your 401(k) slip away

 

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