by David Novak
Last month we discussed dividends, certainly a topic of importance to many retirees. Due to reader questions and general interest in the subject, I wanted to spend a little more time on it.
We previously mentioned how important it is for investors to own stocks in companies that pay consistent and sustainable dividends, meaning they are at little risk of being cut in the future. One of the primary ways to evaluate this is by looking at a company’s payout ratio, which is basically calculated by dividing the annual dividend per share by the earnings (or free cash flow) per share. A payout ratio of more than 100% (i.e. the annual dividend exceeds the company’s annual profits) can be a red flag that the company cannot support the current dividend for the future. While companies can do creative things to maintain their dividends in the short term (such as issuing debt, selling assets, taking cash from reserves, or laying off employees to reduce other expenses), common sense dictates that paying out more than what is coming in is not a long-term strategy.
It is important to note that payout ratios vary by industry. Stocks in sectors such as utilities or telecommunications, which are generally thought of as mature, tend to have high payout ratios, while areas such as technology tend to have lower payout ratios, since managements generally prefer to reinvest cash back into their businesses rather than paying it to shareholders. When considering a stock’s payout ratio, it is most useful to compare it to other stocks in the same industry.
In searching for companies with solid prospects to continue paying the dividends, a good place to start is by looking at a list of dividend “aristocrats”. This is a relatively new term that refers to stocks which have raised their dividend for 25 consecutive years. While this is not a foolproof method, and extreme events can cause any stock to fall off this list, dividend aristocrats tend to have healthy balance sheets, rational and accountable management, and a history of prioritizing shareholders.
One final aspect of dividends to be discussed is reinvestment. When a stock pays a dividend, the shareholder has the option of pocketing the cash, or using it to buy additional shares of the stock (regardless of this decision, the dividend amount is taxable in the year it is paid). Reinvesting dividends over the course of several years can have significant implications in long term returns, as the power of compounding works its magic.
There are some compelling reasons to reinvest dividends, including that generally there are no costs to do so, there are no minimum investment requirements, fractional shares are able to be purchased, and that the entire concept of dividend reinvestment is essentially a form of dollar-cost averaging. This means that more shares are purchased when the stock price is lower, and fewer shares are purchased when the price is higher. This generally results in a lower average cost per share over time.
David Novak, CFP® is a Certified Financial PlannerTM at Novak & Powell Financial Services in Pinellas County. Please note: he is not an attorney and this article should not be construed as one offering legal advice. For information about investment decisions and financial planning, email him at email@example.com.