When investing for dividends, it is always good to keep an eye out for certain red flags or tell-tale signs which may indicate that all is not well. The most important consideration for an income investor is not a high dividend yield, but how sustainable the dividend is. As a simple example, an investor who chases after a 10% dividend yield may see the dividend slashed 80% the following year due to poor business conditions, and end up with just a 2% dividend yield.
There are many factors which influence the level of dividends a company pays and whether the dividend is in danger of being eliminated or reduced. Here are three big risks to take note of for a dividend investor.
1. Is the company borrowing to pay its dividend?
A company’s ability to pay its dividend has to be questioned if it appears as though it is continually borrowing money to sustain the payments. Investors need to realise that dividends are usually paid out of available free cash flow, after accounting for finance payments and capital expenditure requirements.
In other words, dividends should be a part of operating cash flow, which is tied to the core operating profits of a company. The purpose of loans and borrowings is to grow the business, and it is highly suspicious if a company needs to borrow simply to sustain a dividend payment.
2. Is the dividend sustainable based on the prospects of the business?
A business is always forward-looking, and investors should not make the mistake of using a previous dividend as an indication of a company’s ability to continue to pay that same level of dividend. Instead, a careful study of a company’s prospects should be made based on available public information, and an assessment of the business’ future cash-generation ability should be performed.
If the investor feels that the business is suffering from competitive threats, or facing tough business challenges, then there is a chance that the dividend may either be reduced or eliminated. This is a risk an investor has to assess on his own, as the company would not provide advance warning of a potential dividend reduction.
3. Does the business have any upcoming major capital commitments?
A dividend investor also needs to ask himself whether the company he is relying on for dividends has any significant upcoming capital commitments. For instance, if a company has been paying regular dividends for some time but suddenly announces a decision to expand production by building a new factory, this should put investors on the alert for a possible change in dividend policy. Internal funds may need to be routed to the new project, thus reducing the amount available to be paid out as a dividend.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.