With interest rates at historic lows, more and more retirees and other conservative investors have been turning to dividend-paying stocks as a way to achieve higher rates of return on their savings. Gravitas Financial analyst Stefan Muchal explains the basics of dividends and dividend yields and describes what investors should look for when choosing a good dividend-paying stock.
Video transcription
Narrator: Today on “Ask the Analyst” we’re talking about dividends and dividend yields. With interest rates at historic lows, more and more retirees and other conservative investors have been turning to dividend-paying stocks as a way to achieve higher rates of return on their savings. But what exactly are dividends and dividend yields? To provide some insight on this subject, Small Cap Power’s Isis Essery met with Stefan Muchal, an analyst with Gravitas Financial.
Isis Essery: Welcome Stefan. So what exactly is a dividend and a dividend yield?
Stefan Muchal: So a dividend is just a company paying out its excess earnings to shareholders. An example would be you and your friends started a lemonade stand that’s making a lot of money and you have no idea what to do with it, so you would just pay that money back to yourselves in the form of a dividend. You can express a dividend in terms of a yield. So it’s the size of the dividend divided by the market cap of your company.
Isis Essery: Wouldn’t it be better for a company to invest its profits and grow rather than paying a shareholder a dividend?
Stefan Muchal: It all depends on the company. If a company’s in a mature industry like a utility or a REIT, they may have nothing better to do with their money, then they could return it to shareholders, but a company that’s growing and needs to reinvest that money into the company to continue that growth, then it makes sense for them to reinvest the money into the company. So it all really depends on what stage of the life cycle the company’s in.
Isis Essery: What should an investor look for when choosing a good dividend-paying stock, and what are the risks to watch out for?
Stefan Muchal: Incorporating dividends in your portfolio is like beefing up your defensive line. It won’t win you the game, but it will definitely help you not lose. You want to look for companies that have a sustainable dividend, companies that have a low payout ratio. And the payout ratio is the company’s dividend yield divided by their earnings per share. And you also want to see that their current yield is sustainable, they’re not going to cut that in the near future. You can look at metrics like their payout ratio, which is simply their dividends per share divided by their earnings per share. Usually you want this to be less than 60%, which shows that they have some room to maneuver and room to increase their dividend or make sure that they won’t cut their dividend in the future.
Isis Essery: If you were a fund manager how would you structure your dividend-paying portfolio?
Stefan Muchal: So when creating a dividend portfolio, your main goal is income. And to do that, you want to eliminate as much market risk as you can from your portfolio. To do that, you’d create a basket of maybe 20 different companies across a variety of sectors and geographies. You can have companies in the utility space, oil companies or pharmaceutical companies. They all pay dividends.
Isis Essery: What else can a company do with excess profits?
Stefan Muchal: So a company has a few options if it has excess profits. One is obviously they can pay it back to shareholders as a dividend, or they could buy back their own shares, which actually has the benefit of not being taxed twice: once in the company’s hands and once in the investor’s hands. If it wants to reinvest that money into the company, if it has options to do so, it can either do that through acquisition or organically in the business.
Isis Essery: Thank you Stefan.
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