🤔 Think Hard Before You Buy Dividend Stocks - InvestingChannel

🤔 Think Hard Before You Buy Dividend Stocks

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As we touched on last month in The Juice during our retirement series, there are no guarantees in dividend growth investing.

You often hear people refer to “safe stocks,” particularly when they speak of dividend stocks. Frankly, the SEC should ban the word “safe” in association with trading and investing. There’s no such thing. Anything can and often does happen.

In the above-linked article from last month, we used Disney (DIS) stock to illustrate this point. While we still like DIS as a retirement stock, the company did what we’re sure many investors once considered unthinkable: It stopped paying a dividend. After paying a quarterly dividend for more than 40 years, Disney halted the payout in 2020. (It now plans to reinstate its dividend by the end of 2023.) 

So much for the relative safety of dividend aristocrats, companies with a minimum of 25-year track records of annual dividend increases. 

Another even more troubling case in point is AT&T (T)

After being one of the market’s most (seemingly) reliable aristocrats, AT&T cut its dividend in half in 2022 amid its WarnerMedia spinoff. 

While AT&T didn’t get rid of its dividend, it left more than a few retirees with their pants down. For ages, T was the type of stock retirees held (even as the price languished) because they relied on the quarterly and consistently rising dividend. 

The sudden dividend cut meant income effectively cut in half for shareholders who concentrated their retirement savings too heavily in one stock. Obviously a no-no, but sad nonetheless.  

To that end, beyond diversifying your assets, always look out for red flags with dividend stocks. 

As The Juice continues our back-to-basics approach for Q1 of 2023, we define and explain a key metric to consider when assessing dividend stocks: payout ratio.

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🤔 Think Hard Before You Buy Dividend Stocks

Key Takeaways:

  • Payout ratio is one way to assess the sustainability of a company’s dividend. 
  • Generally, the higher the payout ratio, the less stable the dividend. 
  • But there are specific instances when a higher payout ratio isn’t necessarily a red flag. 

With its earnings, a company can do several things. Among the two most popular: 

  • It can reinvest its earnings back into its business to fund future growth. 
  • It can reward shareholders by paying a dividend, usually quarterly, but sometimes annually or just once. 

Payout ratio is how much in dividends a company pays relative to its net income (dividend divided by net income, multiplied by 100 to get a percentage). 

If a company earns $50 million in a year and pays $25 million to shareholders via dividends, its payout ratio is 50%. Is this good or bad? It sort of depends. 

Generally, the higher the payout ratio, the more concerned you should be. If that $50 million a year company pays $45 million in dividends, it has a payout ratio of 90%. It’s probably safe (we can use that word here!) to say that’s never a good situation. Or, at the very least, it’s not a sustainable situation. 

A 50% payout ratio, however, might be perfectly fine for one company, but not great for another. 

Let’s consider some representative, broad examples.  

Apple (AAPL) is an example we love. 

Its payout ratio tends to hover around 15%. This means Apple retains a significant amount of its earnings (around 85%) for other purposes, such as funding its retail operations (which can include opening new stores) and research and development. 

If Apple’s payout ratio was considerably higher (say, more than 50%), it would make sense to wonder if growth might slow (due to lack of reinvestment) or if few growth opportunities exist (given the apparent lack of need to retain a majority of earnings). 

While this is unlikely to be the case with Apple, a company may try to appease shareholders with a handsome dividend it doesn’t have the financial wherewithal to pay out over the long term. 

On the other side of the coin, consider Procter & Gamble (PG). As of early 2023, the company had a payout ratio of around 58%. Seems high. But Procter & Gamble doesn’t have nearly as much cash on hand as Apple does because it doesn’t require the same level of cash to fund and grow operations as a tech company such as Apple does. 

The Bottom Line: Always do specific due diligence into specific companies you’re considering investing in. 

Start from the premise that a payout ratio higher than 50% is a red flag. Investigate the company and reduce or increase your concern from there. 

In some cases, you might have to run. In others, such as with P&G, you’re good to invest. 

With Apple, you can make the (not safe, but logical) assumption that its relatively low payout ratio means it pays a sustainable dividend that will grow over time.

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