Can Dividends Be Dangerous?

Many considered dividends as one of the safest form of returns when investing in the stock market. After all, dividends are actual cash received from the company.  Like the saying goes “A bird in the hand is worth two in the bush”.

Some might not believe it, but there are instances when dividends can actually be dangerous. We’ll take you through the possible pitfalls of dividend investing.

The Issue

The main thing with dividends is that we, as investors, need to ensure that the dividend payouts are sustainable. Companies with high dividend payouts tend to be more popular with investors, and it is possible for the management of a company to artificially boost the dividend payout of the company.

Unsafe Dividends

Not all dividends are created equal. It is possible for the management of a company to artificially boost the dividends by having a payout ratio more than 100%. In order to continue to payout high dividends, management ends up taking on more debt or issuing more shares. Such practice is considered extremely imprudent as it might cause excessive leverage on the company or creates a Ponzi scheme-like dividend, by taking the money from new investors to pay the old investors.

But how do we ensure that dividend payouts are sustainable? For a dividend to be sustainable, it has to be backed by the free cash flow of the company. Let’s use Starhub Ltd. (SGX: CC3) as an example. Starhub has a dividend yield of 4.9%. Although the dividend rate of the company is high, it is considered as a sustainable dividend. This is because the company has a payout ratio within the 100% range, meaning that it is only paying out what it has earned. Secondly, the dividend is well covered by the free cash flow of the company almost every year. Investors in Starhub can breathe a sigh of relief.

Foolish Summary

Dividends are a great source of returns and cash flow for investors. Most retails investors tend to assume (sometimes incorrectly) that dividends are safe. But there can be hidden dangers associated with a high dividend payout. A Foolish investor would do well to check on the sustainability of a company’s dividend payouts before jumping onto the dividend bandwagon. Learn more about dividend investing through a FREE subscription to Take Stock Singapore.Sign up here to The Motley Fool’s weekly investing newsletter that will teach you how to GROW your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim does not own any company mentioned above