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The Importance of Owning Dividend-Paying Stocks – Part 2©
It’s not a requirement for a company to pay a dividend or even have a record of increasing their dividend to qualify it as a good buy. But it’s a very big positive if they do. If a company is not paying a dividend, they need to demonstrate a history of being better at reinvesting their earnings back into the company, for the benefits of the shareholders, than the benefits shareholders could get if that money was paid out in the form of a dividend. In other words, they need to show a track record that they are effectively using the capital that is being generated by the business, by reinvesting it and turning it into a greater return, or they should give it back to you in the form of a dividend. Here are several rules to follow when look at dividend-paying stocks: 1) Don’t try to pick stocks based only on dividend yield. At times, a company will pay a dividend that is above normal for a company in that sector; however, sometimes, that high dividend could be a red flag that the company is in trouble. There are times that a high dividend yield is high because the stock is so beaten up and it may be beaten up for real reasons. This requires some explanation. The dividend to shareholders is paid based on the number of shares that that shareholder has. So if the price goes down, the dividend yield goes up. If a stock is selling at $25 and pays a $1 dividend per share, its dividend yield is 4% ($1 divided by $25). If that stock’s price falls to $20 and it pays the same dividend, its dividend yield will rise to 5% ($1 divided by $20). That fall to $20 could be indicative of major problems in the company, meaning that it should be avoided, or it could be indicative of temporary problems in the company, meaning that it may now be a good value. Further research is necessary. So don’t try to pick stocks based just on dividend yield, because you could potentially get in trouble that way. 2) Look for fundamental evidence that the company is going to be able to maintain their dividend. Since one of the reasons you bought a company was that for that dividend yield, you want to make sure that while you own this company, that you will continue to receive the dividend. A company that has cut its dividend several times will almost certainly have its share price fall; those income-oriented investors who have owned that company primarily for that dividend yield are going to sell it and buy something they consider to be more stable and reliable. So look for fundamental evidence that the company is going to maintain their dividend. 3) Part of that fundamental evidence you need to see is strong free cash flow generation. You want to see a historical record of strong free cash flow, and you also want to see the potential for free cash flow going forward into the future, which can sustain that dividend growth. Probably the most important characteristic that a successful company has is free cash flow. If they do not generate real earnings, also called free cash flow, they probably will not be around for long, for this is the way that good companies fund their growth. These cash earnings, also called “owner earnings,” are different than reported earnings; reported earnings can be manipulated quite easily in the short run. Companies that generate free cash flow are going to have options. Even during tough economic times, they are going to have multiple options, because they have that cash flow. Thus, these companies have the potential to flourish, in both good times and bad. Cash earnings are derived by adding reported earnings to non-cash charges, such as amortization of goodwill and depreciation, and then subtract the capital expenditures required to keep a business running at current production levels. About half the companies in America that report earnings are really not earning money, money that is called free cash flow. One way to evaluate management is to look at what they’re doing with these cash earnings. They can use that free cash flow to:
All of these actions can help buoy and lift stock prices; thus, as an investor, you need to identify companies that have free cash flow, as these companies can create wealth for you on a long-term basis. 4) Is the company growing? Strong and current free cash flow is good, but without growing revenues, where is the new free cash flow coming from? Thus, you, the shareholder, have to pay attention to growth, too. For a certain period of time, if the revenues are flat and the company has a strong market position, it can increase its free cash flow by reducing expenses. But that cannot last forever. There has to be sustained earnings and revenue growth in order to generate sustainable free cash flow. 5) Have a long-term focus. Companies that are growing their dividends on a long-term basis provide tremendous total return potential to shareholder’s portfolios. Remember, over the long term, more than 40% of the return of the market has come from dividend yield. So, everything else being equal, comparing a portfolio with no dividend yield and to one with average dividend yields, the total return potential in the latter portfolio is higher because of that dividend yield. Another way of looking at this is to realize that in the case of that latter portfolio, the equity markets have to appreciate less for that portfolio to do better, because the dividend yield provides a kicker. So in the long term, growing those dividends provides a tremendous total return booster. The long-term total return equation of a stock is typically the dividend yield plus the earnings growth; since on a long-term basis, stocks tend to trade right around their earnings growth, adding in the dividend gives such stocks an advantage over no-dividend stocks. |
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