In these situations, dividends are not favorable

Investors love dividends. Although interest rates are rising rapidly in many markets, they are still relatively low in light of their longer history. These low interest rates mean that investors who have traditionally sought a steady income stream through bonds are now looking for a way to supplement regular cash flows in the form of dividends, further contributing to the overall popularity of these stocks.

Paying dividends is a sign that a company is returning value to you, the shareholder, instead of reinvesting the same income internally in a project that requires capital, such as expanding production or doing research and development to identify future potential, expand revenue further. This is the same reason why dividend-paying companies are generally large, are in mature sectors and, on average, show less market volatility compared to young companies that are still in a growth phase.

On the other hand, when stable dividend-paying companies reduce or even cut their dividends completely, the market sentiment can quickly turn around. Many investors view such a move by a company as a failure of corporate management to maintain value and cash flows, and others see dividend cuts in a specific sector as a sign of headwinds. There are two situations where it is not ideal to receive dividends.

Scenario 1: if the yield is unsustainable

We look at this from the perspective of an investor seeking regular income. If dividends paid are unlikely to be sustainable going forward, investors who rely on these dividends for their own cash flows risk not being able to meet their monthly financial requirements – that’s bad.

One way to find out if this is the case is to look at the dividend amount as a percentage of a company’s earnings per share. share (or in the case of utilities or real estate companies, their cash flows or funds from operations). This goal, the payout ratio, gives you an idea of ​​whether the company is paying too much or too little, and whether the profit is high enough to pay the expected dividend. If the payout ratio is higher than 100%, it means that it pays out more than it takes in profit.

Of course, it can not continue forever unless the company plans to dive into its balance sheet or issue more debt (neither part bodes well for the company’s financial health). This is a point to consider in a stock with an exorbitantly high dividend. Then look at the payout ratio to see if this is sustainable.

Scenario 2: When a company pays dividends instead of investing in growth

We look at this from a growth investor perspective. They may prefer to reinvest the profits in the growth of a company instead of paying out to the shareholders. Why? For growth investors have a long investment horizon and believe that capital has the greatest chance of growing when used to expand a business rather than disappear into the pockets of shareholders.

This is one of the reasons why it is difficult to find high-growth technology companies that pay dividends. These companies reward investors through business growth and potential future earnings and through stock price increases, but not through profit sharing.

In this scenario, a growth company that is starting to pay dividends may signal that it no longer sees good investment opportunities. In other words, the best use of the cash flow is to return it to the shareholder. This can be seen as a turning point for when a business matures. For a growth-oriented investor, it may be time to look elsewhere.

Tips for Dividend Investors:

– Check how dividend income is taxed in your country. In many countries, capital gains are taxed at a lower rate than dividends.

Keep an eye on ‘ex-dividend date’. This is the day you must own the shares to receive the last announced dividend. The market usually quickly prices the value of the dividend into the share price on that ex-dividend date.

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