Yield Curve Strategies
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Six Sigma trainees are classified with a How to Find a Business Partner. And don't give a pass to a company that has recently reduced its dividend but still has a high yield.
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You need to dig into the story, because it isn't uncommon for a company that reduces its dividend to a "more sustainable" level to end up reducing it again or even eliminating it if the business doesn't turn around as expected. A high yield in many cases is a function of investor concern. If Wall Street is worried, you should be too. You may decide that a dividend is secure, but that's a decision to make after you've dug into the story a little bit. One of the first tools an investor should check with a high-yield stock is its payout ratio. This compares the dividend to earnings, and gives an idea of how sustainable the dividend is.
These are rough guides, since every industry is unique. For example, utilities with government-regulated monopolies to sell a vital product like electricity can often support higher payout ratios. But in general, a lower payout ratio is better, and higher numbers should trigger further research. Here's the interesting thing about the payout ratio: Dividends don't actually come from earnings, they come from cash flow.
There are a couple of reasons why this could happen, but they boil down to the fact that earnings are really an accounting number. Things like depreciation and amortization reduce earnings for accounting reasons, but don't actually impact cash flow.
What is yield? definition and meaning - primfonwordpi.tk
That's why REITs with material depreciation expenses related to the properties they own can pay out more in dividends than they earn. In the case of Southern, one-time non-cash charges were the culprit, pushing earnings sharply lower even though the utility's cash flow remained strong. So if the payout ratio is kind of ugly, then your next stop should be the cash dividend payout ratio. This number compares dividends to cash flow to give a more accurate look at whether or not a dividend is sustainable.
Lower percentages are, again, better. If you have a concern about a company's dividend, however, don't stop with the two payout ratios. You also need to take a closer look at the company's balance sheet , which is the financial foundation underpinning the payout. There are a number of different things you can look at here and none are exactly perfect , but one number that is quick and easy is the debt to equity ratio. This basically looks at the company's capital structure to see how much is made up of equity and how much debt.
If debt is a big percentage of the pie, the company is considered highly leveraged. Lower is better, obviously, but anything above 1 should probably be looked at fairly closely. Another tool that builds off the balance sheet, but is actually found on the income statement, is times interest earned. This number compares interest expenses to income to see how well a company is able to cover its interest expenses. So a company with a heavy debt load may be able to pay the associated interest expenses with ease, in which case its debt load isn't as troubling of an issue. However, as times interest earned approaches one, the risks rise.
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And a number below one is a clear sign of financial strain. A higher number is better here. Management essentially had to make a choice between the dividend and spending on growth. With a heavy debt load, the final call was capital investment. The dividend cut was probably the right call for the company, which is again increasing its disbursement, but dividend investors weren't pleased at all.
1. Yield is just one way to look at dividends
That brings us to the next big issue: business models. As hinted above, utilities can generally support higher payout ratios, and higher debt loads, because they are regulated monopolies selling vital products. But a company that's taken on a huge pile of debt to consummate a big merger is a different story.
If the combination doesn't work out as hoped, the extra leverage could end up dooming the dividend. There are a lot of complications that you need to consider. For example, a company that operates in a dying industry think buggy whips at the extreme or within an industry that is prone to volatility like oil and natural gas drilling or one that's highly cyclical steel requires you to think about dividend safety in a different way. Even companies in very stable industries need to be looked at carefully, since a competitor that's falling behind its peers may also end up cutting a dividend to free up cash for other purposes such as investing in growth initiatives.
In other words, the sustainability of the dividend isn't the only thing you need to monitor. You also need to examine the sustainability of a company's business model. A weak business model is just as much of a risk to a dividend as a high payout ratio.
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