Investors seeking income in the current climate of abysmally low interest rates have been turning increasingly to dividend-paying stocks. While this shift is rational and generally appropriate for many, it is also important to understand the risks involved. Dividends present a compelling alternative source of cash flow but are not equivalent to bond or CD income and must be evaluated carefully in view of their specific characteristics and potential downside.
Dividends are a form of return to shareholders paid in exchange for their willingness to risk capital by buying shares in a company. Purchasing shares of stock in a company is a way to acquire partial ownership, in proportion to the total number of shares outstanding. For example, your 100 shares of Microsoft Corp. represent ownership of slightly more than one-millionth of the company. A tiny share, but ownership nonetheless.
Shareholders, as owners of the company, are entitled to all of the profits generated. Dividends are the primary channel through which some of these profits are distributed to owners through cash payments, typically each quarter but sometimes more or less frequently. Dividends are also occasionally paid in kind with more shares of stock in lieu of cash.
However, firms rarely distribute 100 percent of the annual profit but reserve a portion to reinvest in growing the business. This cut of the profits held back for financing future growth is called "retained earnings" and is determined each year by management. The remainder is available to distribute to shareholders in the form of dividends. Investors should research the percentage of profits paid out, called the payout ratio, before investing and be relatively confident that the payout is sustainable.
As one might expect, younger, faster-growing companies need more expansion capital and therefore pay out less in dividends or no dividend at all. Investors in these firms are willing to forgo immediate cash payments in exchange for the prospect of higher stock prices later on if the growth plans come to fruition.
Older, more stable and less rapidly expanding firms generally have higher payout rates and are therefore likely candidates for consideration by investors seeking income. In fact, 418 of the 500 companies in the S&P index pay a dividend, while 70 percent of small public firms in the U.S. issue no dividend at all.
It is important to understand the nature and risks of dividends since so many investors are now increasing their exposure to stocks for income to replace paltry bond yields. While many large, mature firms generally strive to maintain and even grow their payouts, they are by no means obligated to do so. Unlike bond payments, dividend distributions are discretionary and are often reduced or eliminated during periods of financial stress. Investors who bought these stocks for the cash flow are then motivated to dump them, causing the stock price to fall as well (the old double whammy).
Furthermore, it is tempting to chase the stocks with the highest dividend yields in order to maximize cash flow. This is often a suboptimal strategy, given that many of these stocks are candidates for a broad selloff if management slashes an unsustainable payout.
Before pulling the trigger on an income stock, be sure to do your homework. Know the payout ratio and verify that the cash flow generated by the company is sufficient to maintain the distribution going forward. Focus on high quality companies with a strong record of increasing or at least maintaining payouts. And keep in mind that stocks are not bonds, and therefore necessarily bear more risk.
Christopher A. Hopkins, CFA, is a vice president for Barnett & Co. Investment Counsel.