Dividends Good And Bad

It’s nice to be paid money—a dividend—to own a stock, but not all dividends are created equal. Some are safer than others. When a company cuts a dividend, the stock usually plummets. Not good.        

Think of dividend yield as an interest rate. The fictional company Flotsam, which makes Jetsam (in several delicious flavors), sells for $10 a share. It pays a $0.30 per share annual dividend each year to shareholders. Because $0.30 is 3% of $10, the stock’s yield is 3%. If you own 100 shares, Flotsam pays $30 into your brokerage account each year, usually in equal parts four times a year.    

Sounds good, but all businesses and management teams are different. Business, economic and stock market cycles have not been repealed. How do we know if a company can pay its dividend rain or shine, and why do we care?  

A safer dividend is one from a company that only pays out cash it doesn’t need as a cushion or to run its business. A rule of thumb—and there are exceptions—is that to have a dividend margin of safety, a company should not pay out more than 50% of excess cash per year as dividends. If it’s higher, there is increased risk of stock losses.

Consider Flotsam. What if demand softens and Flotsam hasn’t kept enough cash on hand for a rainy recession? It might need to cut its dividend from $0.30 a share to, say, $0.15, to free up some cash. But then at $10, it’s only yielding 1.5%. Many investors will sell to seek better yield elsewhere, wounding the stock. Both yield and stock price profits—on paper, because you haven’t sold yet—are off significantly, with the caveat that if you are reinvesting dividends, you pick up more shares at a lower valuation.

Now assume the opposite, that Jetsam is a necessity. Like toothpaste and deodorant (we hope), people buy it regardless of their circumstances. Flotsam still yields 3%, keeps cash on hand and grows more cash than it needs. Here’s where it gets really interesting (“Finally!” you exclaim).

With its excess cash, Flotsam lifts the dividend over time from $0.30 to $0.39 a share. At $10 the yield is 3.9%, not 3%, so buyers attracted to yield will flock to the stock, bidding up the price. Business performance, inflation and interest rates equal (ha!), heavier buying lifts the stock to $13 to return the yield to 3% (3% times $13 equals $0.39). You, who bought at $10, have a paper profit of 30% and earn 3.9% on your purchase price. Plus, if you keep reinvesting dividends, your shares increase and so too your dividends, a wonderful virtuous cycle!

There is no gain without risk, and there good dividends and risky ones. With attention to dividend margin of safety, your Flotsam and Jetsam are more likely to become Grants and Benjamins.