Owning dividend stocks can mean the difference between receiving income when a company is not growing and taking a loss during that period. The cash or stock payments made to shareholders based on a portion of company earnings signify the financial strength of a company. If a company is willing and able to pay out dividends over time and regularly increase them, it earns favor with shareholders.
There are several things an investor should analyze prior to making an investment in stocks that pay dividends. Most investors elect to focus on the dividend yield, figured by dividing the annual dividend income per share by the current price per share. What this measures is how much income the company received in relation to the share price. If the dividend yield is too low or too high in relation to competing companies, it can signify problems.
Another figure that investors should look at is the dividend coverage ratio. It is the ratio of company earnings to net dividends paid to stockholders. This tells investors whether the company can actually afford to pay a dividend. It is found by dividing earnings per share by dividends per share. If the ratio is low, the company is likely to cut its dividend payment, which can decrease the value of the organization.
A dividend coverage ratio that is two or three is safe but when it falls below 1.5, things get a little hairy. Once the ratio falls beneath one, the company is paying dividends from the previous year’s retained earnings. If the ratio is around five or higher, this may indicate that excess earnings are being withheld. Shareholders begin to wonder why this cash is not being paid to them. When a company increases its dividends, it provides investors with the comforting thought that business will be stable over the next year or so.
Looking at the dividend coverage ratio provides investors with a snapshot of the financial standing of a company. If the ratio is less than one, investors should be wary of how long dividends can be paid from previous retained earnings. If it is over five, they should question why excess cash is being withheld by the company.
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