Who doesn’t love receiving gifts?
Select companies pay their shareholders dividends as a token of appreciation for investing in the business. Doesn’t it feel great to receive something in return? Despite the joyous feeling of Christmas twice a year, receiving dividends also hold great benefits for your portfolio.
What is the best way to spend your dividend payout? The wisest choice is to reinvest those kickbacks. Reinvesting your dividends is a great way to boost your portfolio and returns over the long term. By doing so, you take advantage of the law of compounding interest, allowing your money to accumulate at double the previous rate.
If dividends are so great why isn’t everyone investing in companies that pay dividends? Unfortunately, there is a catch-22 situation with dividends. It isn’t guaranteed. If a company can’t afford to pay its shareholders anymore, it may cut its dividends. Therefore, it is of utmost importance to be particular about the dividend stocks you purchase.
Take the following five thoughts into consideration before buying a dividend stock:
1. Are the dividends growing?
If a company’s dividends are growing it is an indication of the strength of the business.
Dividends only stay attractive when they grow over time. Growth in shareholder payouts shows you that the company is able to grow its revenue sufficiently. Usually, growth in revenue equals growth in dividend yield.
2. Can the company afford to pay shareholders from free cash flow?
3D value investors look specifically for companies that can afford the dividends they pay. A strong business will pay its dividends from free cash flow rather than incur debt to ensure shareholders get paid.
We are not interested in businesses weaving an image of strength while undermining their value. If a company can’t afford to pay dividends from free cash flow, it is using debt or consuming company assets to pay its shareholders. Paying shareholders from any other source than free cash flow is usually a sign that you should run for the hills. It will lead to the company’s demise unless management figures out a way to drastically increase the company’s revenue.
3. Is the company’s revenue growing?
A company that is capable of growing its revenue is a company that will be able to afford and increase its dividends over time.
4. What is the dividend payout history?
To be able to make a conscious decision, when picking a high-yield dividend stock, you should take a look at the company’s payout history. It will reveal whether the company has been able to keep paying dividends consistently. By taking a look at the history, you can determine if there were any dividend cuts or not.
It helps you to determine the strength of the company. If a company can withstand tough times and still afford to pay a dividend to shareholders, it is safe to assume that they will keep paying those dividends no matter what.
5. Is there a moat?
A company with an economic moat always has an advantage over its competitors. If the company has a moat you can rest assured that it will be able to afford and grow its dividend payout over time, unless the company uses its cash to repurchase its shares.
A perfectly healthy business might stop paying dividends for great reasons, for a long-term investment of its own, for example. Under such circumstances shareholders can expect to receive an increased dividend or superior returns later; this is why it’s vital to research the dividend history of a business to get the full picture.
A company’s attitude to its dividends offers a valuable insight into its attitude towards shareholders. However, we believe it is better to buy a business that pays no dividend and delivers superior returns than to buy a business with a healthy dividend yield that it can ill afford.
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