Many companies sport very high dividend yields, but beware these critical warning signs.
Dividend-paying shares give you the security of regular income and historically have outperformed shares that don't pay dividends. Increasingly, investors who value seeing real money come into their investing portfolios -- whether they need it for living expenses or plan to reinvest it into additional shares -- are turning to dividend shares.
With dividend shares, though, having too much of a good thing can cause big problems. Lately, record numbers of companies have been cutting dividends, while precious few have managed to boost their payouts in recent months. Although you'll find strong businesses like BP (LSE: BP) and Unilever (LSE: ULVR) still maintaining or slightly increasing their dividend, far too many companies have gone in the other direction.
Stay Out Of The Dividend Trap
So how do you foresee companies that could have problems sustaining their dividends? Here are a few warning signs to watch out for:
- Too-high dividend yields. Sometimes, businesses are able to create and sustain truly extraordinary amounts of cash to distribute out to shareholders through dividends. Often, though, you'll find that companies whose shares have incredibly high dividend yields are in a position where they won't continue paying as much as they have been -- and the market has already started to adjust for that contingency by pushing the share price lower.
- Unsustainable payout ratios. Another way to gauge whether a company has the financial wherewithal to keep paying its current dividends is to compare them to the amount of earnings the company generates. If a company can't earn enough to cover its dividend payments, then there's a good chance it will have to cut its payout sometime in the future.
- Limited growth. The best way for a company to afford its dividend payments over the years is to grow its business, creating more available cash and leaving room for dividend payments to increase. Without growth, a company has to rely on its core business continuing to be successful -- something that's far from assured in today's economy.
Several shares that meet some of those criteria, such as Legal & General (LSE: LGEN) and HSBC (LSE: HSBA), have actually cut their dividends recently. Here are some other shares that set off alarms:
| Stock | Dividend Yield | Dividend Cover | Current P/E |
|---|
| National Grid (LSE: NG) | 6.4% | 1.0 | 15.0 |
| Man Group (LSE: EMG) | 11.2% | 1.3 | 6.8 |
| Provident Financial (LSE: PFG) | 7.8% | 1.1 | 11.5 |
| Northern Foods (LSE: NFDS) | 7.3% | 1.7 | 8.1 |
(Based on historical data)
Of course, showing up on this list isn't an absolute guarantee that these companies will actually cut dividends soon -- if ever. National Grid, for instance, has a long history of making substantial payouts.
Moreover, if the economy rebounds, then these companies could see their earnings grow dramatically, providing enough income to support dividend yields that will shrink as share prices move up. Nevertheless, it's clear that these shares are under more pressure than many in trying to keep their dividends at current levels.
Be Safe
Picking good dividend shares is like Goldilocks picking the right bowl of porridge. Obviously, you don't want to settle for a company that pays little or nothing to its shareholders. But if paying too big a dividend is a promise that a company won't be able to keep in the long run, buying shares will only bring you losses without giving you the benefits of receiving two big cheques annually for years to come.
So if you have dangerous dividend shares in your portfolio, be careful. You may not need to be in a hurry to sell them, but you shouldn't necessarily rely on the good times lasting forever.
More on the economy and the markets:
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who does not have an interest in any of the companies mentioned in this article.
