A note of caution
Dividends might sound good in this market, but as with any investment, some caveats apply.
First, don’t be tempted by an overly generous payout. True, even blue chip names are sporting yields of 5% and 6% these days due to price declines, but a yield that’s way out of proportion to the rest of the market probably means trouble. “When you see [really high] yields, the market is saying that it doesn’t have a lot of confidence that those dividends will be sustained,â€ says Carlson. Sure enough, there were 61 dividend cuts or eliminations during 2008, as companies, including many in the financial sector, have either suspended or cut their dividends in the last year.
One way to tell whether a company can afford to continue paying is to look at its payout ratio, the proportion of earnings going toward dividends. The lower the ratio, the more likely the dividend is safe. “I would look for a stock that pays no more than 60% of earnings to shareholders,â€ says Sam Stovall, chief investment strategist with Standard & Poor’s Equity Research in New York. A company still needs to retain some earnings or cash flow to invest back in the business.
Also, look for companies with a history of increasing their dividends, such as those that populate the Standard & Poor’s Dividend Aristocrats list, which have raised their dividends in each of the past 25 years. “If you’re buying a stock for its income, then you want that dividend to grow and grow and create enhancement to your purchasing power,â€ says Peters.
And, finally, steer clear of firms carrying too much debt. Paying back lenders takes precedence over shelling out for dividends.
This story originally appeared in the June 2009 issue of Black Enterprise magazine.