Some Risks Inherent To High-Dividend Paying Stocks
The Morningstar Dividend Investor recently advised about five risks that you should pay close attention to when investing in high-dividend paying stocks.
1. Pay attention to payout percentages.
The payout ratio is, by definition, the ratio of dividends to earnings. And danger looms if company earnings drop while the company is paying at a higher dividend rate. Any company that distributes more than 80 percent of its earnings as dividends should immediately raise a red flag.
2. Be very cautious about borrowing.
Whenever a firm is taking on debt in order to keep dividends high, it's a signal that management is gambling that operating cash flow will bounce back. But what if it doesn't?... All the more reason for an investor to be cautious about borrowing!
3. Seek steady growth.
The ideal business is one in which revenue and income from the company's core businesses will be growing by at least 6 percent a year on average. And any company that isn't keeping pace with major factors in the economy such as inflation and/or the long-term U.S. GDP growth rate, is a company that will not be around to pay out dividends in the long run.
4. Learn to appreciate uniqueness in a business.
Warren Buffett uses the term "wide economic moats" to describe uniqueness in a given business. This refers to advantages that are difficult for competitors to copy - like strong brand names and proprietary processes - which can help to insulate a business from competitive threats and economic recessions.
5. Watch closely any expansion costs.
The more a company spends on growth, the less money it has available for paying dividends. So whenever you subtract capital expenditures from the operating cash flow, the resulting number should exceed the amount that was paid out in dividends. If it does not, the company may not be able to finance future growth and also reward its shareholders - and do both things at the same time!
The 2003 change in the tax laws have made high-dividend paying stocks more attractive, but never invest without first paying close attention to the five risks as noted above.
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1. Pay attention to payout percentages.
The payout ratio is, by definition, the ratio of dividends to earnings. And danger looms if company earnings drop while the company is paying at a higher dividend rate. Any company that distributes more than 80 percent of its earnings as dividends should immediately raise a red flag.
2. Be very cautious about borrowing.
Whenever a firm is taking on debt in order to keep dividends high, it's a signal that management is gambling that operating cash flow will bounce back. But what if it doesn't?... All the more reason for an investor to be cautious about borrowing!
3. Seek steady growth.
The ideal business is one in which revenue and income from the company's core businesses will be growing by at least 6 percent a year on average. And any company that isn't keeping pace with major factors in the economy such as inflation and/or the long-term U.S. GDP growth rate, is a company that will not be around to pay out dividends in the long run.
4. Learn to appreciate uniqueness in a business.
Warren Buffett uses the term "wide economic moats" to describe uniqueness in a given business. This refers to advantages that are difficult for competitors to copy - like strong brand names and proprietary processes - which can help to insulate a business from competitive threats and economic recessions.
5. Watch closely any expansion costs.
The more a company spends on growth, the less money it has available for paying dividends. So whenever you subtract capital expenditures from the operating cash flow, the resulting number should exceed the amount that was paid out in dividends. If it does not, the company may not be able to finance future growth and also reward its shareholders - and do both things at the same time!
The 2003 change in the tax laws have made high-dividend paying stocks more attractive, but never invest without first paying close attention to the five risks as noted above.
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posted by Bob Moser at
7:50 PM
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