I got another question about dividend paying stocks on quora:
Why wouldn’t I buy dividend paying stocks? Are there risks?
So I took a minute this morning and recorded a video showing what kind of risks, you need to look out for.
There are many steps that have to occur in order for you to receive a steady dividend. First, the company has to make a sale. Then that sale has to convert into actual earnings for the corporation. After that, the company has to decide to pay out the dividend. And finally, the company has to elect to pay the dividend. After all that you receive money in your account.
Each one of these steps presents risk.
Risk #1: Sales Growth
Are the sales for this companies business growing? Are the following question mark on a steady? How reliable is a sales forecast into the future? These are questions you need to have answers to. Any projection about the future is going to have uncertainty, but you want to gain as much certainty and clarity as possible.
Risk #2: Earnings
Earnings are a much debated topic in the stock market world. Over the past few years, we’ve seen the rise of non-GAAP accounting as a major practice. What this means is that the company will report earnings excluding what they call one-time charges and other accounting gimmicks. The issue is that if company has one-time charges are year, then they are not really one-time charges. You have to know how much money the company is really clearing out of the sales. Some people look to Free Cash Flow as a better measurement of this than earnings.
So you have to do your due diligence in order to make sure that the earnings of the company are steady, growing, or falling. Hopefully, the earnings are growing over time because this is where your dividends come from.
If a company decides to pay dividends in excess of real earnings, that means that that they are eating into their balance sheet. They are disturbing cash that they cannot afford to lose.
If the company does that long enough it will go bankrupt.
See you have to make sure on your end that the earnings will support the dividend payout.
Some types of companies like real estate investment trusts (REITs) are required to distribute at least 90% of their earnings, but other than that, most companies will distribute a much smaller percentage of their earnings.
Risk #3: Dividend Payouts
When a company chooses to pay dividend, it creates a set of problems for itself from a public relations perspective. Any company wants to have the highest price possible in order to attract investment over time so that current shareholders can sell into the market at a profit. Paying a dividend is one way to attract investors because a lot of investors view dividends as more rewarding and safer than playing capital speculation. And those investors are correct.
The issue comes in when something happens to the earnings discussed in risk number two. In some companies the boards have decided to keep paying dividends even though there’s a market downturn, either for the economy as a whole or for this to their company. So they are willing to go negative in dividend payout for a short time because their long-term perspective is that the market will come back and the dividend will become a safe payout ratio again.
Other companies decide to more frequently change their dividend to reflect market conditions.
As the shareholder, typically you want your dividend to be the most reliable possible. So you’ll prefer a steady payout instead of a dividend that comes and goes. And that makes sense as long as the sales in the earnings support that over the long term. So again, check back to risks number one and two.
The last risk, and to some degree the least important, is the actual price of a share. If you’re a dividend investor, then the most important thing is how much money you are receiving on a quarterly or annual basis. So the day-to-day share price doesn’t matter so much. What can happen though is that market conditions change and the share price will reflect those changes. So you have to keep somewhat of an eye on the price to see if the business itself has been impaired.
But not all share price changes are reflective of the actual business. In an overall market boom or an overall market crash, the cost of buying and selling shares is not directly related to the value of that underlying business. In fact value investors make entire careers out of exploiting these differences between share price and actual value of the underlying business.
But you still have to do your continual due diligence in order to make sure that the business that you own a piece of is continuing in a healthy way. So the share price provides a sort of barometer for that health.
Overall, the risks of buying dividend paying stocks are lower than the risks of non-dividend paying stocks. The cash in your pocket cannot be taken away. Whereas the value of shares in the market can fluctuate wildly. This is a major reason why I strongly dislike the trend of share buybacks of corporations.