What Dividends Tell You

Ah, lovely dividends. What better way to juice your stock-appreciation returns than by enjoying regular cash payments from your companies?

Dividends can tell you a lot about a company -- perhaps more than you think. For starters, there's the obvious: A dividend yield of 2% means you can expect to earn 2% in cash (or reinvested in additional shares) per share on top of any stock-price appreciation from your stock. Not a bad deal.

In a nutshell
First, the basics. A dividend is a portion of a company's earnings that it pays out to its shareholders. If the Home Surgery Kits Co. (ticker: OUCHH) is earning roughly $4 in profit per share each year, it might decide that it will issue $1 per share annually to shareholders. If so, it will probably pay out $0.25 per share every three months.

This may seem like a pittance, but it adds up. If you own 500 shares of a company that's paying $1 per share in dividends, you'll be receiving $500 per year from the company.

If you're evaluating a company's dividend, make sure you're looking at its dividend yield -- the current annual dividend divided by the current price. Here's why it matters: If two companies are each paying $2.50 per share in dividends, but one company is trading at $25 per share and the other at $50 per share, you'll get more dividend per invested dollar with the first company. Its dividend yield is 10%, versus 5% for the second company.

Remember that since the dividend yield is essentially a fraction, with the annual dividend on top and the share price on the bottom, it will fluctuate daily, as the share price fluctuates. (Annual dividend amounts will change only every year or so.)

The meanings of dividends
Here are some thoughts on what dividends can tell you:

• A company paying a dividend sports a financial condition that is probably fairly stable. If a company is paying out $0.25 per share in dividends, it should be fairly certain that it will always have enough cash on hand to cover that obligation. Better still, companies with track records of regularly and significantly hiking their dividends tend to be extra-consistent earners, ones you can count on to deliver over the years. (Paychex (Nasdaq: PAYX) and Nokia (NYSE: NOK), for example, have hiked their dividends by a compound annual average of more than 25% over the past decade.)
• Companies paying dividends are generally healthy. It's true that some companies end up reducing or eliminating their dividends, but they usually try to plan like heck to avoid that. (Some companies that have eliminated dividends over the past few years include Xerox (NYSE: XRX), Corning (NYSE: GLW), and Nortel (NYSE: NT).)
• As a stock price rises, the yield will fall, and vice versa. So a hefty dividend yield may on the one hand reflect a generous company -- but it may also reflect a struggling firm whose stock has tanked. Never snap up shares of a stock just because of a fat yield. It may be tied to an ailing firm about to cut its dividend. (Citizens Communications (NYSE: CZN), for example, sports a recent yield around 7%, but its annual dividend amount of $1 per share is considerably higher than its recent earnings per share for the past 12 months, $1.09. That means the firm is paying out some 92% of its earnings in dividends, leaving it little wiggle room.)
• If a company pays a dividend, it means it has extra cash that it doesn't have a pressing need for. Remember, with its earnings, a company can reinvest in its business (hiring more people, building more factories, placing more ads, etc.), pay down debt, buy back shares, buy another company, etc. If it chooses to pay a dividend with some of that money, it's consciously deciding against the other options, presumably because they wouldn't deliver better returns to shareholders. This is why younger, more rapidly growing companies tend to not pay much, if anything, in the way of dividends -- they need their cash to help grow their business.

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Longtime Fool contributor Selena Maranjian owns no shares of any company mentioned. Citizens Communications is an Income Investor recommendation. The Motley Fool is Fools writing for Fools.