Dividend stocks seem great – as an investor, they can put cash straight in your pocket almost from day one. But this isn’t always as good as it sounds.
Anyone thinking of getting started with investing needs to be aware of what the downsides are when it comes to dividend shares. And a lot of investors miss these.
Passive income
The obvious attraction to dividend shares is that they’re one of the few sources of genuinely passive income. Investors just buy a stock, do nothing, and wait for the cash to show up.
Unilever (LSE:ULVR) is a great example. Whenever someone buys a jar of Marmite or a bottle of Domestos, some part of the profit finds its way back to shareholders.
The company also operates in a relatively defensive industry, which means demand is likely to be stable over time. As a result, it has been a pretty reliable source of income over long periods.
Investors, though, should think about whether they really want this to happen. Cash today might be a good thing, but it’s not the only thing that matters from an investment perspective.
Competitive pressures
In the last 12 months, Unilever has brought in £1.89 in earnings per share and distributed £1.57 in dividends. This means most of the firm’s profits are being returned to shareholders.
There are two ways of looking at this. One is that it’s bad – cash returned to investors can’t be reinvested into growing the business and this is risky in an industry where switching costs are low.
The other, though, is positive. Unilever has managed to grow its earnings per share over the last 10 years even while returning most of its profits to shareholders and that’s a very strong sign.
I’m on the side that says the firm’s high payout ratio is a sign of unique long-term strength. But I don’t think investors can afford to ignore the competitive risks entirely.
Valuation
Even if Unilever’s dividend doesn’t risk the company’s competitive position, there might be another reason to be wary. It might not be the most efficient way to return cash to investors.
Right now, the stock trades at a price-to-book (P/B) ratio of 6.6. This implies that every £1 the company has in equity on its balance sheet translates to £6.60 in market value.
In other words, if Unilever returns £1 from its net assets to shareholders as a dividend, they get £1. But if they sell £1 in equity, they get £6.60.
Given this, a dividend might not be the best thing for investors overall. This depends on the P/B ratio staying above 1, but it’s got a long way to fall for that to change.
Think carefully
For some people, there’s no substitute for getting cash distributions from an investment. And for anyone in that situation, dividend shares are probably a fine choice.
But my point is that investors shouldn’t just look at the current yield or its history. They need to look more closely to figure out whether or not a dividend is really in their best interests.
In the case of Unilever, I’m not entirely convinced. I do hold the stock, mostly for diversification purposes, but I’m focusing on opportunities with stronger growth prospects right now.
